What is a bond covenant?
A bond covenant is a legally enforceable promise written into the bond’s governing documents that sets rules or obligations for the issuer (borrower). Covenants are intended to protect bondholders’ chances of getting paid while also clarifying what the issuer may or must do during the life of the bond.
Core definitions
– Indenture: the formal contract for a bond issue that includes the covenants and other legal terms.
– Affirmative (positive) covenant: a clause that requires the issuer to take specific actions (for example, provide audited financials or maintain insurance).
– Negative (restrictive) covenant: a clause that forbids certain actions (for example, limits on additional borrowing or capital spending).
– Technical default: a covenant breach that, even if interest and principal payments are up to date, gives creditors certain remedies (such as acceleration of debt or other penalties).
– MADS (maximum annual debt service): the largest amount of principal plus interest due in any single year; used in some coverage covenants.
Why covenants matter
– They reduce lender/investor risk by limiting actions that could weaken creditworthiness.
– They give bondholders legal grounds to seek remedies if the issuer strays from agreed terms.
– Covenant strength affects market perceptions and ratings; looser covenants typically offer less protection and may be reflected in credit assessments.
Types of common covenants
– Reporting and transparency requirements (affirmative): regular audited statements, certifications, notice of material events.
– Financial maintenance tests (negative): limits on leverage (e.g., total debt / EBITDA) or requirements for minimum interest coverage (EBIT / interest expense).
– Restrictions on additional indebtedness (negative): bans or limits on issuing more secured or unsecured debt.
– Limits on dividend payments or asset sales (negative): to prevent transfers that could impair repayment ability.
– Change-of-control provisions (negative): restrict actions following major ownership changes.
Short checklist for reviewing bond covenants
1. Locate the indenture and read the covenant section.
2. Identify affirmative obligations (reporting, insurance, tax compliance).
3. Identify negative restrictions (debt incurrence, dividends, asset sales).
4. Note the exact covenant ratios and testing dates (e.g., quarterly, annually).
5. Check remedy language — what happens if a covenant is breached (grace period, cure rights, acceleration)?
6. Look for cross-default or cross-acceleration clauses tying this bond to other debt.
7. Assess materiality and monitoring — are the reporting requirements frequent and detailed enough?
8. Consider who enforces the covenant (trustee, bondholders) and how easy it is to trigger remedies.
Worked numeric examples
Example A — Interest coverage covenant
– Covenant requires EBIT (earnings before interest and taxes) / interest expense ≥ 3.0.
– Company A has EBIT = $9 million; interest expense = $3 million.
Calculation: 9 / 3 = 3.0 → covenant satisfied.
– If interest expense rises to $4 million: 9 / 4 = 2.25 → covenant breached (technical default risk).
Example B — Leverage covenant (debt / EBITDA)
– Covenant requires total debt / EBITDA ≤ 4.0.
– Company B has total debt = $180 million; EBITDA = $50 million.
Calculation: 180 / 50 = 3.6 → covenant satisfied.
– If debt increases to $220 million: 220 / 50 = 4.4 → covenant breached.
Practical notes on violations and consequences
– Many agreements include cure periods or waivers; some breaches can be remedied before creditors accelerate remedies.
– Common consequences include ratings downgrades, higher borrowing costs, or formal enforcement by creditors.
– Credit-rating firms monitor covenant quality; a deterioration in covenant protections can weaken a bond
‘s recoveries and market value, and can make enforcement more likely if operating performance deteriorates.
Common covenant-related terms and enforcement mechanics
– Event of default (EOD): a contract-defined breach that gives creditors the right to pursue remedies. Typical EODs include nonpayment, covenant breach that is not cured within any allowed cure period, false representations, and bankruptcy filings.
– Acceleration: a remedy that allows creditors to declare the entire principal (and unpaid interest) immediately due. Acceleration is often subject to trustee action and may require a majority of bondholders to consent.
– Trustee: a neutral third party named in the bond indenture to monitor compliance, notify holders of defaults, and take enforcement action on their behalf. Retail investors cannot direct a trustee’s actions except by coordinating with other holders through bondholder committees.
– Cross-default: a clause that causes a default on one instrument to trigger defaults on others if certain thresholds are met. This links different financings and can accelerate systemic enforcement across lenders.
– Negative pledge: a restriction preventing the issuer from granting new secured liens that would have priority over the bondholders’ claims unless the bondholders are protected or equalized.
– Pari passu (equal ranking): a clause stating that two classes of debt share equally in claims against the issuer, subject to senior/subordinated distinctions.
– Waiver and cure: many agreements allow the issuer to cure a breach within a specified number of days, or allow bondholders (often by a specified majority) to waive a breach in exchange for concessions.
Practical worked examples
1) Sensitivity check on a leverage covenant (debt / EBITDA)
– Covenant: debt / EBITDA ≤ 4.0.
– Starting point: debt = $180m; EBITDA = $50m → 180 / 50 = 3.60 (compliant).
– Scenario: EBITDA falls 10% to $45m → 180 / 45 = 4.00 (at limit).
– Scenario: EBITDA falls 11% to $44.50m → 180 / 44.5 ≈ 4.04 (breach).
Step-by-step use: 1) identify the covenant formula; 2) create base-case numbers; 3) stress-test reasonable downside scenarios (10%, 20%); 4) check whether cure mechanisms (e.g., temporary waiver period) exist.
2) Using asset sale proceeds to cure a breach (cure example)
– Covenant: fixed-charge coverage ratio (cash flow available for debt service / interest expense) ≥ 1.2.
– Company: interest expense = $8m; cash flow available = $9.6m → 9.6 / 8 = 1.20 (compliant).
– If cash flow falls to $8.8m → 8.8 / 8 = 1.10 (breach).
– Suppose the issuer can immediately sell an asset and use $2m net proceeds to pay down debt that lowers interest by $0.5m (new interest = $7.5m). If cash flow remains 8.8m, new ratio = 8.8 / 7.5 ≈ 1.173 (still below 1.2). This illustrates that cures can require both raising free cash flow and reducing obligations; check whether sale proceeds are permitted for this purpose (some negative pledge language restricts use).
Checklist for investors assessing bond covenants
1) Read the indenture/term sheet — identify all covenants and definitions (especially how metrics like EBITDA are calculated). Definitions matter.
2) Note thresholds and measurement dates (quarterly, trailing 12 months, pro forma).
3) Find cure periods, waiver mechanics, and vote thresholds needed to approve waivers or amendments.
4) Check ranking and security: secured vs. unsecured, senior vs. subordinated, and any negative pledge language.
5) Look for cross-default and cross-acceleration triggers and their dollar or percentage thresholds.
6) Identify special events: change-of-control put rights, permitted liens, permitted debt baskets.
7) Assess trustee powers and practicalities of enforcement (is the investor pool dispersed or concentrated?).
8) Run sensitivity scenarios on cash flow, EBITDA, and debt levels to estimate breach probabilities.
9) Consider covenant-lite features: absence/weakness of maintenance covenants, heavy reliance on incurrence covenants (triggers when new debt is issued), and broad exceptions.
10) Incorporate covenant strength into relative value: stricter covenants generally improve creditor protections but may coexist with lower yields.
Covenant-lite loans and bonds — what to watch for
– Definition: “Covenant-lite” (cov-lite) refers to loans or bonds with fewer or weaker maintenance covenants (fewer periodic tests of financial ratios), relying more on incurrence covenants (tests that occur only when the borrower takes specific actions).
– Implications: faster issuance and greater borrower flexibility, but reduced early warning for lenders and potentially lower recoveries in stressed scenarios.
– Historical note: cov-lite structures were common in leveraged loan markets before the 2007–2009 crisis, then contracted, and later expanded again in benign credit conditions. That history is instructive: weaker covenants can amplify losses during downturns.
Negotiation and market context
– Corporates with stronger bargaining power (high credit quality, unique assets, strategic buyers) can often negotiate fewer covenants. Distressed issuers or those needing financing typically accept tighter covenants.
– For retail bond buyers: you cannot renegotiate terms after issuance, so price and covenant terms at issuance determine protection. Secondary-market purchasers should check the indenture before buying, not assume protections exist.
Quick reference formulas
– Leverage ratio: total debt / EBITDA.
– Interest coverage: EBITDA / interest expense (or EBIT / interest expense depending on agreement).
– Fixed-charge coverage: (cash flow available for debt service) / (interest + scheduled principal + lease payments).
Note: always confirm exact definitions and adjustments in the indenture (e.g., add-backs to EBITDA).
How trustees and bondholder committees act in practice
– Trustees monitor and may be required to notify bondholders of potential defaults.
– Many enforcement actions (
) are resolved by negotiated waivers or amendments rather than by suing and foreclosing. Litigation and formal enforcement are costly and slow; trustees, bondholder committees, and issuers typically prefer structured workouts that preserve more value for creditors. That said, when negotiations fail or collateral is at material risk, trustees can and do pursue remedies.
Common enforcement/remedy options
– Notice and cure: Issuer receives formal notice of default and a defined cure period (e.g., 30–90 days). If cured, no further action is taken.
– Waiver or amendment: Bondholders (usually by vote) may waive a covenant breach or amend the indenture, often for a fee or improved terms (e.g., higher coupon, collateral pledge).
– Acceleration: Trustee declares principal and accrued interest immediately due. Acceleration typically requires a specific default (e.g., payment default) or a supermajority vote when permitted.
– Foreclosure or repossession: For secured debt, trustee may foreclose on pledged assets and enforce liens.
– Injunctions/receivership: Court may appoint a receiver or issue injunctions to preserve assets.
– Bankruptcy filing: Either issuer files voluntary bankruptcy to restructure, or secured creditors seek remedies through bankruptcy courts. In bankruptcy, covenants are often modified or subordinated by the restructuring plan.
How trustees and bondholder committees typically act in practice
– Monitor and notify: Trustees must monitor compliance and notify bondholders of defaults or material events when the indenture requires it.
– Seek direction from holders: Trustees owe duties to beneficiaries (bondholders) and often need holder instructions before expensive enforcement; that may require votes and indemnities.
– Negotiate rather than litigate: Trustees commonly negotiate waivers, forbearance agreements, or amendments because those preserve value for the creditor body.
– Form committees in distressed situations: Large, institutional holders may form official or ad hoc committees to coordinate strategy, negotiate with the issuer, and fund enforcement or restructuring efforts. Retail holders usually have limited influence unless aggregated.
Practical checklist for bond investors (retail and secondary buyers)
1. Obtain the indenture (bond contract) before buying. Check the trustee and note any special definitions (e.g., EBITDA adjustments).
2. Identify covenant types present:
– Affirmative covenants (issuer must do X)
– Negative covenants (issuer must not do Y)
– Financial covenants (ratios with test dates)
– Events of default (what triggers remedies)
3. Note measurement and timing:
– Which definition of EBITDA/interest is used?
– Test frequency (quarterly, semiannual, annual)
– Grace and cure periods for defaults
4. Check security and priority:
– Is the bond secured? What collateral?
– Pari passu (equal ranking) vs. subordinated clauses
– Intercreditor agreements (if any)
5. Find amendment and voting provisions:
– What percentage of holders is needed to amend a covenant or waive default? (Typical: majority >50% for routine changes
) — larger thresholds (commonly 66 2/3% or 75%) are often required to change core economic terms (maturity, ranking, interest rate) or to release significant collateral.
6. Remedies and acceleration
– What remedies does the indenture give noteholders if a covenant is breached? Typical remedies include acceleration (declaring principal due), appointment of a receiver, or foreclosure on collateral.
– Is acceleration automatic on certain defaults (e.g., nonpayment) or discretionary (trustee must act)?
– Are remedies subject to a holder-direction clause (majority of holders can direct the trustee)?
7. Cross-default and cross-acceleration
– Cross-default: a default on other indebtedness (over a specified threshold) can trigger a default on this bond.
– Cross-acceleration: acceleration of other indebtedness can result in acceleration here.
– Look for materiality thresholds (e.g., cross-default only if other indebtedness > $10m).
8. Change-of-control, optional redemption and make-whole provisions
– Change-of-control: does the issuer have to offer to repurchase bonds at a specified price if control changes? Typical buyout is 101%–103% plus accrued interest.
– Optional redemption (call): when can the issuer redeem early and at what price? Check call schedule and any step-downs in premium.
– Make-whole: a make-whole call price attempts to compensate holders for lost future coupons; understand the discount rate used (e.g., Treasury + spread).
9. Reporting, notices and information rights
– Does the issuer have to provide audited financials to holders or the trustee? Frequency (quarterly, annually) matters.
– Are there covenants tying to specific reporting events (e.g., delivery within X days after fiscal year-end)?
– Note holder rights to information or to inspect books (often limited).
10. Subordination, intercreditor and negative pledge clauses
– Subordination clause: spells out which obligations rank ahead of these bonds in bankruptcy.
– Intercreditor agreements: if present, these govern relationships among secured creditors.
– Negative pledge: issuer agrees not to grant superior security to other creditors without securing these bondholders’ parity.
11. Amendment, waiver and consent mechanics (practical points)
– Which votes are required for different types of amendments? Example: 50.1% to amend a technical covenant; 75% to change principal payment terms.
– How are consents solicited and validated? Via trustee, with proof of ownership (CUSIP-level), and record dates.
– Watch for “non-consent” clauses that protect minority holders from changes that materially and adversely affect them. These are less common but critical.
Investor checklist — quick due diligence steps
1. Obtain the indenture (trust deed) and any supplemental indentures. Primary source: bond prospectus/official statement or EDGAR for U.S. issuers.
2. Read definitions first — many disputes boil down to how terms like “EBITDA,” “consolidated,” or “Permitted Liens” are defined.
3. Identify every covenant and classify (affirmative, negative, financial).
4. Note test frequencies and lookback or pro forma adjustments.
5. Calculate the most common financial covenants using the issuer’s latest financials.
6. Check amendment, waiver and voting thresholds.
7. Search for cross-default, acceleration, and change-of-control triggers.
8. Flag any high-priority security or intercreditor arrangements.
9. Verify reporting requirements and whether audited figures will be supplied.
10. Note trustee identity and whether bond is registered/physical or in book-entry form.
Worked numeric examples
A. Interest-coverage ratio (ICR) covenant
– Covenant: ICR ≥ 3.0, where ICR = EBITDA / Interest Expense (both on a trailing-12-month basis).
– Given: trailing-12-month EBITDA = $120 million; trailing-12-month cash interest expense = $40 million.
– Calculation: ICR = 120 / 40 = 3.0 → covenant test met.
– Stress scenario: interest rises to $50 million (e.g., higher floating rates or new debt).
– New ICR = 120 / 50 = 2.4 → breach.
B. Leverage covenant (Net leverage)
– Covenant: Net Debt / EBITDA ≤ 4.0.
– Given: Total debt = $500m; Cash = $50m → Net Debt = 450m. EBITDA = $120m.
– Calculation: 450 / 120 = 3.75 → covenant test met.
– If EBITDA falls to $100m: 450 / 100
– Calculation: 450 / 100 = 4.5 → covenant test failed (breach).
C. What happens after a covenant breach — key terms and likely outcomes
– Event of Default (EOD): a formal contract-defined breach that gives lenders certain rights (e.g., accelerate debt, demand immediate repayment, take collateral). Not every covenant violation automatically becomes an EOD — loan agreements typically specify cure periods or grace periods for certain breaches.
– Acceleration: lenders can declare outstanding principal and accrued interest immediately due if an EOD is not cured or waived.
– Remedies available to lenders: enforce security interests (foreclose or appoint a receiver), sue for damages, negotiate restructuring, or grant a waiver/forbearance in exchange for concessions.
– Forbearance: a temporary agreement by lenders not to exercise remedies while the borrower implements a plan (usually comes with conditions).
– Waiver: a formal written consent by lenders that retroactively or prospectively excuses the breach (often for a fee and sometimes with additional covenants).
– Cross-default / cross-acceleration: a breach on one instrument can trigger defaults on other instruments if agreements include cross-default or cross-acceleration clauses.
D. Example outcomes and numerical illustrations
– Example 1 — waiver fee plus spread increase:
– Situation: Company breaches ICR and seeks a waiver from banks who hold the $500m term loan.
– Typical lender terms (illustrative): one-time waiver fee = 2.0% of principal; ongoing spread increase = +200 basis points (bps) on floating-rate debt.
– Calculations:
– Waiver fee = 2.0% × $500m = $10.0m (one-time cash outflow).
– Prior interest expense (given) = $40m/year (implied average rate ≈ 8.0%).
– Additional annual interest from spread increase = 2.0% × $500m = $10.0m → new annual interest ≈ $50.0m.
– Result: short-term liquidity need = $10.0m (waiver fee) and higher recurring interest cost (+$10.0m/year) that may deepen future covenant pressure.
– Example 2 — equity cure (if allowed by agreement):
– Equity cure: owners inject equity that either reduces net debt (via paydown) or increases EBITDA coverage indirectly.
– If the sponsor injects $60m to pay down debt:
– New total debt = $500m − $60m = $440m; cash reduces accordingly (assume cash used).
– New net debt = 440 − 50 = 390m; with EBITDA = $100m → Net Leverage = 3.90 → covenant back in compliance.
– Tradeoffs: dilution for shareholders; may require lender consent depending on the facility.
E. Practical, step-by-step immediate actions after you identify or anticipate a breach
1. Stop and verify numbers:
– Recalculate the covenant using the exact definitions in the credit agreement (look for add-backs, pro forma adjustments, treatment of fees, and timing conventions).
– Confirm trailing-period windows and whether pro forma items (acquisitions, dispositions) are allowed.
2. Assemble a covenant package:
– Create a concise packet with calculated covenant tests, supporting schedules (EBITDA bridge, interest detail, debt schedule), and a forward 12-month cash/EBITDA forecast.
3. Communicate early and transparently:
– Notify the agent bank or lender contact per the notice provisions. Early dialogue improves chances of a collaborative solution.
4. Run scenario analysis:
– Project outcomes under base, stressed, and remedial scenarios (e.g., interest up 100–300 bps; EBITDA down 10–
–30%; currency swings; one-off costs). For each scenario, produce the covenant math month-by-month (or quarter-by-quarter) over the covenant measurement window so you can show exactly when and why a breach occurs and whether it is temporary or persistent.
– Build remedial scenarios that show the effect of specific actions (equity injection, asset sale, covenant cure payment, cost cuts, refinancing). Present the minimum action that restores compliance and incremental options (partial cure vs full cure), with pro forma covenant ratios after each action.
Worked numeric example (leverage covenant)
– Covenant definition (example): Leverage Ratio = Net Debt / LTM EBITDA must be ≤ 3.5. (LTM = last twelve months; Net Debt = Total Debt − Cash.)
– Base case: Total Debt =