Role of Debt Covenants

A bond indenture is a formal written agreement between the issuer of the bond such as a corporation and the bondholders.

This agreement specifies in detail the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.) These rights and obligations are known as covenants and protect creditors by restricting activities of the borrower.

Affirmative Covenants: These are the borrower promises to bond holders, for example, the borrower may be required to maintain a minimum of certain ratios, such as minimum interest coverage ratios, or minimum cash flow levels. The borrower also promises the timely payment of principal and interest.

Negative Covenants: These covenants constrain borrowers form certain activities. They are also called restrictive covenants as they restrict borrower activity. Common restrictive covenants include various limitations on the company’s ability to incur additional debt. Bondholders may want to include limits on the absolute dollar amount of debt that may be outstanding. The bondholders may also want to put a restriction on sale of assets that are pledged as collateral.