Lesson 5 of 5 · 14 min
Covenants: affirmative versus negative
Covenants are the enforceable promises in an indenture: affirmative covenants say what the issuer must do, negative covenants say what it must not do, and both give bondholders recourse if broken.
In short
- Covenants are legally enforceable terms agreed at issuance; they are bondholders' main source of influence, since bondholders have no votes.
- Affirmative covenants (must do) are mostly administrative and cheap for the issuer: use of proceeds, timely financial reports, redemption at a premium if the issuer is acquired, pari passu and cross-default clauses.
- Negative covenants (must not do) restrict actions: limits on liens, sale and leaseback, mergers, additional debt, dividends and buybacks, investments and asset disposals, and a negative pledge.
- Lower-quality issuers face more covenants, including financial ratio tests and an incurrence test that must be met before taking certain actions.
- Breaches give recourse: changed financial terms (higher coupon, more security), accelerated payments or termination. Too-tight covenants can force an avoidable default.
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