A covenant in legal and financial terms refers to an agreement, a condition, or a bond issue that requires a borrower to follow certain rules that prevents the borrower from engaging in certain activities, or which places restrictions on certain activities when other circumstances are satisfied. In loans and bonds, covenant places a limit on how much more a buyer can lend.
Bottom Line: Lenders generally set up covenants to protect themselves from borrowers defaulting on certain loan conditions due to financial instability.
A Little More on What is a Covenant
Covenants are generally represented in terms of financial ratios that must be preserved, like a limit on debt-to-asset ratio or other ratios used in measuring them. Covenants can be applied to anything related to making of payments in the finance sector. If a covenant is violated, penalties can be applied or the loan can be called. When a loan is called, it means that the Acceleration Clause has started according to legal provisions. In this situation, the borrower will be required to repay the loan with immediate effect. Simply put, when a loan is called, the deadline for the loan starts at that immediate moment, regardless of the initial repayment date. Loan covenants come in two forms: affirmative covenants and negative covenants.
In an affirmative (or positive) covenant of a loan agreement, a borrower is required to maintain different positive actions. These actions include but are not limited to the maintenance of optimum insurance levels, requirements to send over financial audits to the creditor, compliance with set regulations, maintenance of accounting records, and possibly maintenance of credit ratings. When an affirmative covenant is violated, there is a tendency of outright disqualification. However, in some cases, the borrower might be granted a grace period to take care or correct the violation. If he is unable to do this, the lender is entitled to declare default and “call” the loan.
Negative covenants unlike positive covenants usually target what a borrower is not allowed to do rather than what he is expected to do. These covenants are set up to refrain the borrower from causing harm to their credit ratings, which may in turn impair their ability to repair the loan. Negative covenants are mostly in the form of financial ratios which borrowers are required to preserve at the time of the financial report. Some covenants require a borrower to maintain a certain amount of debt to earnings ratio, and this amount is not expected to surpass a designated maximum amount in order to prevent the company from getting into more debt can it can repay. Another example of negative covenant is the interest coverage ratio which states that a business’s earnings before interest and taxes (EBIT) must be higher than the interest payments by a designated multiple. This ratio helps prevent any occurrence of the inability of a borrowing entity to repay its existing loans by making sure that it generate enough earnings.
- Covenants in legal and financial terminology implies those actions that should and shouldn’t be carried out.
- Being a legal binding contract, if a covenant is breached or violated, it can carry stiff penalties
- Positive covenants state what should be done, while negative covenants state what shouldn’t be done.
Violation of Bonds
Bond violation refer to the breaching of a bond’s covenant. Bond covenants are basically included in the bond’s indenture of the bond agreement, and they are meant to protect the interest of both parties involved. When a bond issuer breaches a covenant binding the bond, it can be referred to be in technical analysis. Unlike loan covenants, bonds cannot be “called,” so the appropriate default for breaching a bond covenant is the decrease of the bond’s rating. Decreasing a bond’s value can make it unattractive to investors and inflate the cost of borrowing on the part of the issuer. Moody’s one of the biggest and most respected credit rating agencies in the United States rate bonds on a scale of 1 to 5, with 5 being the worst rating a bond can get. If a bond has a rating of 5, it is a sign that the issuer is most likely violating the covenant consistently. Moody’s reported in May 2016 that the average ratings of bonds has decreased from 3.8 to 4.65 from the previous month. Th company stated that this was as a result of bad bonds as well as junk bonds. Junk bonds are usually bonds with stringent covenants that can be easily broken without committing an action that is significant enough to be termed a default.
Bond Covenant Examples
Hennepin County, Minnesota on the 23rd of June 2016 issued a municipal bond to assist in financing a portion of the county’s ambulatory outpatient located at their medical center. A credit ratings agency, Fitch Ratings gave the bond an AAA rating since it was backed by the full faith and credit of the county. The agency also gave the Hennepin County Regional Railroad Authority limited tax obligation bonds an AAA rating for the same purpose stated above. This ratings were made because the county is able to pay the bond at any time using ad valorem taxes on all properties eligible for taxation. The covenant in the Hennepin County bond debenture stated that Hennepin County is allowed to levy taxes to finance the debt service at 105% annually. The debenture further stated that the cap limit of the tax rate offer a reliable support of the debt service of 21.5 times MADS.
We’ll also like to look at the March 2018 report by Mayer Brown LLP on the high bond yields by German real estate firms. This firm (Mayer Brown LLP) noted that another competitor, Corestate Capital Holding S.A (S&P: BB+) based in Luxembourg joined the firms which were issuing debt. This note however represented a smaller portion in the firm’s total capital structure, thus making them incapable prior to their maturity since they are not traditional high yield bonds. The German law also at that time stated that they needn’t contain a full traditional covenant package. Thus, no restrictions can be placed on Corestate to prevent it from distribution to its child firms. Also, there was no presence of an affiliate transactions covenant.
These two illustrations represent the two different types of loan covenants. The first was a negative covenant as it restricted the tax level to a maximum of 105% of the debt service. The second certainly was a positive or affirmative covenant as it allows for no restrictions on distribution.