Covenant
What is a Covenant?
In finance, a Covenant is a formal agreement or clause in a loan contract or bond agreement that sets certain conditions or restrictions on the borrower. These terms are designed to protect the interests of lenders or investors by ensuring the borrower maintains financial health and behaves responsibly.
Covenants are legally binding, and a breach can trigger penalties, increased interest rates, or even default.
Types of Covenants
Covenants are broadly classified into two categories:
1. Positive Covenants (Affirmative Covenants)
These are obligations the borrower must do.
Examples:
- Maintain a minimum level of working capital
- Provide regular financial reports to the lender
- Pay taxes and insurance on time
2. Negative Covenants (Restrictive Covenants)
These are things the borrower must not do.
Examples:
- Cannot take on additional debt without approval
- Cannot pay dividends beyond a certain limit
- Cannot sell key assets without consent
There are also financial covenants that are either positive or negative but focus specifically on financial performance.
Financial Covenants (In Detail)
These covenants ensure the borrower remains financially stable. Common examples include:
- Debt-to-Equity Ratio: Limits the amount of debt relative to equity.
- Interest Coverage Ratio: Ensures the company can cover interest payments from its earnings.
- Current Ratio: Requires the borrower to maintain a certain level of liquidity.
Example:
A lender may require that the borrower maintain a debt-to-EBITDA ratio below 3.5x. If the ratio goes above that, it could trigger a technical default.
Why Are Covenants Important?
For Lenders or Investors:
- Protect their capital
- Allow early warnings of financial trouble
- Provide legal rights to intervene if needed
For Borrowers:
- Build trust and creditworthiness
- May result in lower interest rates if strong covenants are in place
Consequences of Covenant Breach
Breaking a covenant is known as a covenant breach or default, even if the borrower is still making payments. Consequences may include:
- Renegotiation of loan terms
- Increase in interest rates
- Acceleration of loan repayment
- Legal action or penalties
- Triggering of cross-default clauses (default on one loan leads to default on others)