What Is a Bond Covenant?
Let me explain what a bond covenant really is. It's a legally binding term in the agreement between you as a bond issuer and the bondholder. These covenants exist to protect the interests of both sides. You'll find negative covenants that stop the issuer from doing certain things, and positive ones that demand specific actions be taken.
Understanding Bond Covenants
You need to understand that bond covenants outline activities that must be done or are strictly forbidden by the bond issuer. These are enforceable clauses, and breaking them triggers compensation or legal action. They're part of every bond's legal docs, whether corporate or government bonds, and they last until the bond matures. Think of the indenture as the section holding these covenants—positive and negative alike. For instance, they might limit additional debt, require audited statements, or cap new investments. If you violate one as an issuer, you're in technical default, which could downgrade your bond's rating and hike your costs. Ratings agencies like Moody's score covenant quality from 1 to 5, with 5 being the worst, and they've noted weakening quality in recent times.
Affirmative Bond Covenants
Affirmative covenants, or positive ones, are promises you make as the issuer to do certain things. This includes keeping adequate insurance, sending audited financials to lenders, following laws, and maintaining proper books or credit ratings. If you break these, it's usually an outright default, though some bonds give a grace period to fix it. Otherwise, creditors can demand immediate repayment of principal and interest.
Negative Bond Covenants
Negative covenants restrict you from actions that could weaken your credit or repayment ability. Common ones involve financial ratios you must maintain, like not letting debt-to-earnings exceed a set limit, to avoid overloading on debt. Another is the interest coverage ratio, ensuring your earnings before interest and taxes cover interest payments sufficiently. These keep you in check so you can service the debt.
Example of Bond Covenant
Take the case of Hennepin County, Minnesota, in 2016. They issued a bond to fund part of a medical center, rated AAA by Fitch due to the county's strong backing. The covenant required levying taxes to cover debt service at 105% annually, with a maximum tax rate offering 21.5 times coverage of maximum annual debt service. This shows how covenants tie into tax powers for security.
Key Takeaways
- Bond covenants set required or forbidden activities for issuers.
- They're legally binding and breaching them leads to default actions.
- Affirmative covenants mandate actions like maintaining insurance.
- Negative covenants restrict harmful actions like excessive debt.
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