Covenants are legally enforceable rules that parties (borrowers and lenders) agree on. The purpose is to protect bondholders by providing some assurance on what the bond issuer will and won’t do over the life of the bond. There are two types of covenants.
Affirmative (or Positive) Covenant
These covenants require a party to do something, are administrative in nature and do not result in additional costs. They do not materially limit the issuer’s freedom while executing day-to-day business operations. Affirmative covenants essentially require the issuer to adhere to certain terms. These may include:
- Outlining what the issuer can do with the proceeds from the bond issue;
- Obligating the issuer to promising to return the principal of a loan at maturity; or
- Obligating the issuer to comply with laws and regulations, insure assets adequately, or deliver timely audit reports.
On the other hand, negative covenants state what issuers are forbidden from doing (or simply not to do). These covenants are legally binding on the issuer, costly, and materially limit business decisions. Examples include:
- Barring the issuer from taking on additional debt;
- • Imposing a maximum acceptable debt ratio (such as leverage or gearing ratios) or a minimum acceptable interest coverage ratio;
- Restricting asset disposals, distributions to shareholders, or engagement in (risky) investments; or
- Explicitly ruling out mergers and acquisitions of any form unless certain conditions are met.
Which of the following is an affirmative covenant?
A. The issuer will not be paying dividends in excess of 25% of EBIT
B. The issuer will insure at least 75% of operating assets
C. The issuer has a predefinition of both maximum debt-to-equity ratio and minimum times interest earned to 1.0
The correct answer is B.
Insuring assets adequately is a positive covenant, while options A and C are examples of negative covenants.
A negative covenant for a senior bondholder is the constraint on:
A. The issuance of a more senior loan
B. How to spend cash from the proceeds of bond issuance
C. Complying with group transfer pricing policies
The correct answer is A.
Options B and C are all affirmative covenants. They are administrative in nature and do not limit operations of business.
Reading 42 LOS 42c:
Compare Affirmative and Negative Covenants and identify examples of each