Covenants are actions which the issuer commits to take (in case of affirmative/positive covenants) or not (in case of negative covenants).
Affirmative covenants
Affirmative covenants are typically administrative in nature; they list what issuer would do with cash proceeds from bond issues, comply with laws and regulations, maintain current lines of business, etc. Negative covenants differ from affirmative covenants in that they restrict the issuer’s business actions. They are meant to protect bondholders from dilution of their claim, asset withdrawals/substitutions, and suboptimal investments.
Negative covenants
Examples of negative covenants include:
- Restriction on raising new debt: specifying maximum debt ratios and minimum coverage ratios.
- Negative pledges to prevent issue of debt senior to the current debt.
- Restriction on prior claims stops the issuer from using general assets as collateral for new debt.
- Restrictions on distributions to shareholders specifying the maximum percentage of earnings which can be utilized in paying dividends or share buybacks.
- Restrictions on asset disposals specified as a maximum percentage of company’s gross assets.
- Restrictions on investments prevent new risky investment or may commit the issuer to stay in the current line of business.
- Restrictions on merger and acquisitions unless the issuer is the surviving company, or a new bond indenture is issued preventing the issuer from avoiding obligations to the bondholders.
The above list is not exhaustive. The main purpose of the negative covenants is to make sure that the issuer honors its obligations to the bondholders, but they should not be too restrictive because otherwise, they could force the issuer to default when the default is avoidable.