I Want You
To subscribe to our newsletter

* Required
Please enter a valid email address.
Please enter your first name.
Please check this box if you want to subscribe.
Thank you for subscribing to The Financial Pipeline! You will be receiving an email shortly to confirm your subscription.
Sorry, there was a problem with registration. Please try again.

What Is A Bond Covenant?

Bond covenants are utilized to restrict the borrowing firm from making decisions which will deteriorate its financial health from the time of borrowing.

A covenant is a pledge or undertaking by an issuer to do certain things or avoid others.

In the bond market, a covenant will usually be a “financial covenant” which specifies that, for example, the issuer will maintain an interest coverage ratio over a certain level or a leverage ratio (debt/equity) under a specific level. These ratios are meant to constrain the issuer to financial prudence.

Covenants can also be “non-financial” in nature, such as providing financial information to bondholders, protecting against the selling of assets, or changes of control, or making sure the assets of the company have adequate insurance.

Both types of covenants are utilized to restrict the borrowing firm from making decisions which will deteriorate its financial health from the time of borrowing. Covenants can also reward investors or punish borrowers based on their financial health. Covenants can add coupon step-ups based on credit metrics or credit ratings.

Issuers do not like to have covenants because they restrict their actions. This is why the majority of recent bond issues do not have meaningful covenants. These structures have become known as Cov-Lite deals. Issuers tend to provide more stringent covenants in a slow bond market when they are having trouble raising money, and inversely will provide very few covenants in a hot bond market where investors are willing to forego the safety of covenants just to get access to the issue.

Issuers with outstanding “covenant” bond issues have “closed off” these issues and currently issue debt under their unsecured debenture and mid-term note programs. This is one of the reasons for the development of “asset-backed securities”.

These asset-backed securities enable bond investors to obtain specific assets as security and protective features in bond issues. Instead of investing in an unsecured mid-term note of an auto-finance company, an investor could invest in “auto-loan” receivables through an asset-backed trust originated and serviced by the same company.

While covenant lite deals or ‘Cov-Lite’ deals are cyclical, the key for investors is understanding the protections that they are legally entitled to. Some issuers are willing to pay a higher coupon to be able to remain flexible with their covenants. Issuers that are involved in a lot of acquisitions financed with debts need to be able to access the debt markets on a regular basis and having a restrictive financial covenant could impair their ability to make deals. As an investor you have to be compensated for the additional risk that comes along with having fewer restrictions on what the borrower is able to do.

3 years ago

Follow us on Twitter to always be financially aware


Follow us on Linkedin to always be financially aware