Common Restrictive Covenants in Fixed Income Securities

It is important for investors investing in fixed-income securities to be aware of restrictive covenants. This is because restrictive covenants can have a huge negative impact on the valuation as well as the liquidity of the debt. Bond indentures are detailed legal documents that can have many covenants which prove to be restrictive. However, there are some covenants that are commonly used to restrict the actions of the firm. These covenants are called restrictive covenants and have been described below.

Covenants Restricting More Debt

Investors which hold fixed income securities have an interest in ensuring that the companies they lend money to do not go on a borrowing spree and then go bankrupt. As a result, most investors will try to enforce companies to include some restrictive covenants in their indentures. The purpose of this covenant is to limit the amount of debt which a company can undertake.

  • It is common practice to restrict the amount of debt based on the cash flow being generated by the firm. Hence, such firms need to maintain an interest coverage ratio. This means that if the cash flow from their operations must cover the interest a certain number of times. For instance, if the interest coverage ratio in the covenant is capped at 2, then the firm cannot have interest expenses increasing by $100 if its total cash flow from operations is $200.

  • Investors must realize that if they restrict the firm’s ability to borrow money, then the return generated by the firm will also reduce. Hence, certain types of debt are commonly excluded from the restrictive covenants. This includes debt such as lease obligation, acquisition-based debt, debt issued by foreign subsidiaries, etc.

  • It is also common for covenants to place a restriction on borrowing debt with the same or higher level of seniority. However, debt that is unsecured or has lower seniority may be exempted from such covenants

  • Sometimes, companies create different debt baskets and have different credit limits with specific details for each. Some of these limits may be expressed in dollar terms whereas others may be expressed in terms of coverage ratios.

Covenants Restricting Liens

Investors who hold fixed-income securities generally secure their debt by creating liens on the assets of the firm. If multiple liens are created on the same assets, then it is possible that the seniority of the investors may be compromised and hence their invested capital might be jeopardized. It is, therefore, in the interest, of the investors to regulate the creation of further liens by creating legal hurdles.

Investors may write a covenant that states that any lien created on the company’s assets without their explicit consent should be considered illegal and invalid. There are some types of lien that may be excluded from this requirement. It is common for companies and investors to negotiate specific dollar amounts up to which liens can be created. Sometimes, these dollar amounts are expressed in terms of percentages which vary as the results of the company vary.

Covenants Restricting Asset Sales

The claim that the fixed income security investors have over the firm is secured with the assets of the firm. Hence, it is obvious that firms will try to protect these assets and also prevent their sale. Asset covenants make it necessary to seek the approval of the debt holders before selling any significant assets. Also, these covenants explain the procedure which needs to be followed in order to arrive at the fair market valuation of an asset. It is common for covenants to prohibit the trading of assets in kind.

These covenants require that the asset be sold for cash or cash equivalents. The use of the proceeds of sale is also regulated by covenants. Some indentures may allow investment in growing the business and related companies whereas others may not. Similarly, some indentures may allow the buyback of debt and/or equity while others may prohibit such activities. There may be specific restrictions such as the sale of assets to related parties on credit. Some covenants may also prohibit the use of sale and buyback agreements.

Covenants Restricting Change of Ownership

Many times, investors are afraid that a change in the ownership of the company would end up jeopardizing their interests. As a result, they often explicitly include clauses that clearly state the course of action which will be taken in case of a change in ownership.

For instance, some investors may invest in having a put option on the bond which can be exercised if there is a change in ownership. Such an option may make it mandatory for the firm the first buy the bond at an agreed-upon price before the change of ownership can be completed. For instance, the firm can be forced to buy the bond at 110% of the market value before the change of ownership. If the firm fails to do so, then the bond investors can start legal proceedings for default.

Many times, these covenants are structures in such a way that a mere change of ownership does not trigger the covenants. In such cases, some other conditions also need to be fulfilled for the put to become valid. For instance, the credit rating of the entity must also fall down along with the change of ownership to trigger the put option.

The reality is that most bond contracts are standardized. Hence, the indentures and covenants are also standardized. However, it is not extremely uncommon for bonds to have restrictive covenants. In fact, such covenants are commonplace when high yield bonds are considered.

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