Every bond in the bond market is nothing more than a really big loan from the investors to the issuing company or municipality. This is true of U.S. Treasury bonds, corporate and municipal bonds. When the bank lends you money, there are pages of legal terminology listing the conditions of the loan and promises you must make to get the money. These are loan covenants. Bond covenants are part of the legal documents that appear in the bond prospectus and carry the promises made by the borrower to the investors.
Every new bond is issued with covenants, which list the responsibilities borne by the issuers, such as timely payment of interest and principal, the amount of interest payable and the dates, the maturity date and any call provisions or sinking funds. There are many other covenants, particularly important when buying high-yield bonds. The bond trustee monitors the issuer's compliance with the covenants and takes remedial action if they are not followed.
Types of Covenants
Affirmative covenants stipulate what the bond issuer must do according to the agreement, such as perform according to the basic terms of the issue, pledge certain property or maintain certain financial levels. Negative covenants stipulate what the bond issuer is prohibited from doing, such as carry more than a stated amount of debt, sell assets or do business in a certain country.
Restrictive covenants are those that provide extra protection for the investors. Companies include such restrictive covenants because they reduce the risk to the investor and, therefore, result in a lower interest rate for the company to pay. Restrictive covenants limit management decisions and the influence of shareholders on the amount of debt the company may carry, assets that can be sold, mergers and change of management. They also stipulate reporting requirements to the bondholders. Restrictive covenants are most often found on junk bonds -- those with lower than BBB/Baa credit ratings.
Bond covenants, even if restrictive or negative, can't turn a bad investment into a good one. If the company is financially weak, bond covenants can't improve the finances, so it is always better to avoid bonds that have high interest rates and a long list of covenants unless you are a bond expert. Bond covenants also don't truly restrict bad management from making bad choices. They can help position the bondholders to receive more favorable treatment in the event of company liquidation, but this is not a reason to buy a bond from a company that is likely to go into default.
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