Covenants Meaning Types Restrictions Examples

Covenants Meaning

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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 bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more dealings or debt Debt Debt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read moretransactions.

Understanding Covenants

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 creditorCreditorA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more, investor, or debt holder.

Key Takeaways

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.

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 principalLoan PrincipalLoan Principal Amount refers to the amount which is actually given as the loan from the lender of the money to its borrower and it is the amount on which the interest is charged by the lender of the money from the borrower for the use of its money.read more 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 issuersBond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more 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.

Applicability

A covenant is often addressed in the financial marketFinancial MarketThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more as either a financial or debt covenantDebt CovenantDebt covenants are formal agreements between different parties like creditors, suppliers, vendors, shareholders, investors, and a company, establishing limits for financial ratios such as leverage ratios, working capital ratios, and dividend payout ratios, which a debtor must refrain from breaching.read more.

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 ratiosFinancial RatiosFinancial ratios are indications of a company’s financial performance. There are several forms of financial ratios that indicate the company’s results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more and computations, including interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company’s current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company’s liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more, debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more, 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.

Restrictions

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.

Types of Covenant

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 ratingCredit RatingCredit rating process is the process in which a credit rating agency (preferably third party) analyzes a security and rates it accordingly so that the stakeholders can make their investing decisions.read more, 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 acquisitionMerger And AcquisitionMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more (M&A) deals, etc.

Suppose a breach is observed, leading to default. In that case, the lenders might either provide a grace periodGrace PeriodGrace periods are extra days given after the due date to undertake an unfulfilled obligation without penalties. They are a common instance in the financial world and are usually offered to clients who apply for a credit card, student loan, insurance, or mortgage to attract more customers.read more for the damage control or ask for immediate repayment of the principal amount plus the interest.

Covenant Examples

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 creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more 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 issueIt can’t issue equityIt 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 assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more 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.