The Role of Debt Covenants in Protecting Creditors

Debt covenants are restrictions included in bond indentures that protect creditors by restricting the activities of the borrower. They are beneficial to the borrowers to the extent that they lower the risk to the creditors and thereby reduce the cost of borrowing.

How Debt Covenants Protect Creditors

Affirmative covenants restrict the borrower’s activities by requiring that certain actions be undertaken. For example, a covenant may require that the borrower maintains its current ratio above a certain level.

Negative covenants prohibit the borrower from undertaking certain actions. For example, they may restrict the borrower’s ability to invest, pay dividends, or make other decisions that may adversely affect the company’s ability to repay its debt.

Typical debt covenants include:

• limitations on how borrowed monies can be used;
• maintenance of any collateral that is pledged as security;
• restrictions on future borrowings;
• requirements that limit dividends;
• requirements to meet specific working capital requirements; and
• minimum acceptable levels of financial ratios, such as the debt-to-equity ratio.

A violation of a debt covenant is viewed as a breach of contract. Depending on its severity, as well as the terms of the contract, creditors may choose to waive the covenant, invoke their entitlement to a penalty payment, renegotiate the contract, or call for debt repayment.

Question 1

Which of the following is most likely to be included in a debt covenant that protects creditors?

1. A requirement that employees work for more than 40 hours per week.
2. A limitation on how money received from the bond issuance can be used.
3. A requirement that the company pays less taxes than required under applicable tax legislation.

Solution

The correct answer is B.

A limitation on how money received from a bond issuance can be used is a typical covenant which serves to protect the interests of creditors.

Options A and C are very unlikely to be seen in a debt covenant.

Question 2

Negative covenants are assumed to put restrictions on the borrower’s ability to:

1. Pay dividends.
2. Issue additional debt.
3. both dividends payments and issuance of additional debt.

Solution

The correct answer is C.

Negative covenants aim to control the borrower’s ability to use its earnings in activities that could affect their ability to pay the loan’s principal and/or interests.