Types of Covenants

In the previous article, we had a closer look at the concept of covenants as well as indentures. However, we only covered the basics. Indentures and covenants are extremely important to the investors who deploy their money in fixed-income securities. It is for this reason that investors need to have a better understanding of the various types of covenants as well as how they impact investment decision-making.

Why Covenants are Vital?

Fixed income securities have two important features which distinguish them from a standard bank loan. Firstly, these securities are held by a wide variety of people. Secondly, these securities are held over a very long period of time.

Now, since the securities are held by a large number of people, any change in the indenture will require a legal process. This legal process is often very detailed and also very expensive. Hence, issuers have an interest in getting the covenants right for the first time itself so that they do not have to spend the additional money. Also, since the securities are held for very long periods of time, they should not be so restrictive that they do not allow the company to pursue normal growth.

Lenders have the right to control the cash flow of the firm. However, if the controls are excessively strict, they might end up eroding the underlying business which generates the cash flow. This would end up doing more harm than good. Hence, both these conflicting objectives need to be balanced while drawing up the covenants as well as the indenture.

Incurrence Vs Maintenance Based Covenants

Covenants can be classified in multiple ways. One of the ways to look at covenants is to check whether they are incurrence based or maintenance based. Incurrence-based covenants restrict the actions of the company when it tries to take some additional action.

For instance, the company needs to comply with the covenants when it mortgages its property, sells its assets, or raises more debt. Unless these events take place, the company does not have to comply with these covenants. On the other hand, there are other types of covenants which are called maintenance-based covenants. These are covenants which the company has to comply with on a regular basis. In such cases, the borrowing company has to provide a quarterly update to their investors about their compliance with the covenants.

Link Between Covenants and Equity Shares

To the uninformed investor, it might seem like covenants only affect debt and that they have no bearing on the equity shares which are issued by the company. However, this is not the case because of two reasons:

  • The valuation of equity shares is heavily influenced by the growth rate of the company. However, if a company has signed on for debt that has very restrictive covenants, then their growth can be negatively affected. In some cases, debt holders want to ensure that funds are always available to pay off their debt. As a result, they restrict the amount and type of investments that a firm can make. This significantly impairs the future growth potential which in turn also impairs the value of equity shares

  • Secondly, dividends are also very important to many equity shareholders. There are several shareholders who invest so that they can have access to regular cash flow at a later stage. Restrictive covenants jeopardize the needs of such investors as well. As a result, they start selling their equity shares which ends up lowering the price of these shares.

Covenants Which Help All Stakeholders

Over the years, debt holders have realized that they cannot pressurize the management of the company into managing the debt well. Instead, they need to partner with the organization. As a result, they have started coming up with covenants that are favorable to all parties. From an investor's point of view, it is essential to validate whether the covenants are beneficial to all stakeholders.

Some examples of such covenants have been mentioned below:

  • Covenants should allow the firm to invest in joint ventures or buy out other companies as long as the investment is below a certain amount that has been negotiated in advance. Companies should not have to lose out on lucrative acquisition opportunities because of restrictive covenants

  • Covenants should allow companies to have a negotiated amount for transactions with unrestricted subsidiaries. This amount should be expressed in terms of a percentage of profit. Hence, if a firm generates more profits, it should have more funds at its disposal to make such transactions.

  • Companies should be allowed some flexibility in restructuring the debt. This means that they should be allowed to replace subordinated debt with debt that has been raised on similar conditions. A lot of the time, companies are not able to take advantage of the low cost of capital since their covenants do not allow them to replace or roll over debt. This unnecessarily raises the cost of capital and hurts the debt holders as well.

The bottom line is that bond covenants are quite pervasive in nature. The impact the interests of the management, equity shareholders as well as holders of fixed income securities. It is for this reason that fixed-income security investors need to carefully study the covenants before making an investment.

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