Covenants

Covenants are terms imposed by creditors in a debt arrangement or deed that the borrower must comply with while abstaining from executing specific acts. The lender's intention behind including such a clause in the contract is to prevent the borrower defaulting. In other words, it is the borrower's written promise to follow certain dos and don'ts while taking out a loan.

The contract includes the dos and don’ts for the borrowers so that the lenders do not lose out on their money at any cost. The one who puts conditions is a covenantee, while the other committing to the terms is the covenantor. Covenants seem necessary to be introduced and implemented in bond dealings or debt transactions.

• Covenants are a set of promises borrowers make to ensure lenders are not trusting an insecure deal. 
• It is a standard clause of the bond contracts and loan agreements whereby lenders secure their lent amount against defaults. In short, these act as a shield or protection against the lenders’ lent amount.
• It is classified into two types – positive and negative.
• In case of a breach, the lenders might either provide a grace period for repayment or ask for immediate payment of the principal amount plus the interest.

Covenants are a set of clauses that lenders decide and specify in a debt/loan agreement to secure the amount that borrowers are to owe them. The conditions are normally determined based on the credit handling capacity of the borrowers involved. There are times when the lending institutions are ready to lend an amount, but there is a lack of trust when dealing with the borrowing party. A covenant is a sort of security against the amount they lend to another party. A lender can either be a creditor, investor, or debt holder. 

When companies decide to issue bonds to raise capital, they end up borrowing a lot of money from lenders. As a result, they miss out on interest payments and gradually become incapable of paying even the loan principal amount. As a result, the lenders put restrictions on borrowers to make sure the latter clear their debts on time. In addition, the contract passes on the power from bond issuers to bondholders who invest in the debt securities.

The amount is lent to the borrower only when they agree to the clauses the lender has imposed.

A covenant is often addressed in the financial market as either a financial or debt covenant. 

• A financial covenant is a promise made by a borrower in financial terms. For example, in this case, the clauses are available in terms of various financial ratios and computations, including interest coverage ratio, debt to equity ratio, etc. 
• On the other hand, a debt covenant is a commitment that lenders (via an agreement) want the borrowers to fulfill. This is only an attempt to ensure the former secures the lent amount against any kind of default.

However, the terms financial and debt covenants are often used as substitutes as they both imply the same meaning and indicate the imposition of clauses by the lenders on the borrowers. Another term that can also be alternatively used in this context is banking covenant.

The concept of covenant in real estate is a bit different. It is a recorded document that restricts what a landowner can do with the property. It is either enforceable by an association or individual owners. 

Of course, covenants are restrictive in nature. However, given the loan amount involved and the security that lenders rightfully need on the amount they lend, the imposition of certain clauses is fully justified. As soon as these standard clauses become active, they restrict the power of the borrowers.

The borrowers, mainly the companies taking up a significant amount to raise their capital, are commonly found defaulting on interest payments and then missing out on paying the principal amount. Through this, lenders specify the dos and don’ts for the borrowers to ensure the latter does not involve in anything that could lead them to default.

• Covenants restrictions help lenders prohibit borrowers from taking actions that might adversely affect their repayment pattern or increase any kind of risk for the former.
• When the borrowers are involved in such a deal, the cost of borrowing is lower than usual. In short, they get loans approved from the lender at a lower interest rate.

These restrictive specifications are classified as positive and negative.

Positive

It is affirmative in nature, specifying what borrowers must do to ensure timely repayment to lenders. It contains a list of factors that influence the productivity of the company borrowing the money. For example:

• Having a sound working condition,
• Having adequate insurance schemes,
• Compliance with applicable laws and rules,
• Regular maintenance of capital assets,
• Maintenance of credit rating, etc.

Negative

It contains a list of things that the borrowers refrain from doing to avoid defaults. The list of clauses in this respect mostly includes the limited total debt to a certain earning ratio. This ensures the company is not burdened with too much debt, difficult or even impossible sometimes to repay. If that happens, repaying the covenantee would automatically become tough. Some of the examples include no:

• Sale of certain assets,
• Borrowing of more money,
• Involvement in other agreements, 
• Partake in merger and acquisition (M&A) deals, etc.

Suppose a breach is observed, leading to default. In that case, the lenders might either provide a grace period for the damage control or ask for immediate repayment of the principal amount plus the interest. 

Let us consider the following examples to understand the concept better:

Example 1

Company A plans to issue covenants bonds worth $10 million, for which it approached a few lenders and offered to pay interest of 8%. However, after proper evaluation of the creditworthiness of FFC, a lender decided to put a few points for them to commit to before buying the bonds.

• FFC can’t issue any other bonds of the same seniority after this issue
• It can’t issue equity
• It will have to maintain an Interest Coverage Ratio of 3

So, FFC requires following all the above clauses to raise funds worth $10 million.

Example 2

Recently, Moody’s introduced the Sponsor Financial Covenant to ensure loan sponsor Progress Residential Trust complies with the same, which, in turn, will make the latter’s investment and other activities unrestricted. The clauses included the maintenance of:

• Net assets of at least $150,000,000 (inclusive of direct or indirect interest applicable)
• Net assets of a minimum worth of $90,000,000 (exclusive of direct or indirect interest applicable)

The covenants as specified were to ensure no event of default.

This is a guide to what are Covenants, their Types & Examples. Here we also discuss how does it work despite multiple restrictions. You can learn more about the related topics from the following articles –

• Capitalization Cost
• Recapitalization Meaning
• Bank Credit Meaning
• High Yield Bonds