Purpose of Debt Covenants
There are many different financial instruments and ways to invest. One way is to buy corporate debt, also known as bonds. When an investor buys a bond, he enters into an agreement with the company about how the money will be repaid--such as how long the business will take to pay the bondholder and at what interest rate. While buying debt is usually less risky than buying stocks, bondholders can lose their money if a company goes bankrupt. Thus, creditors may require a company to make additional concessions and agree to behave in a certain way, to protect their investment. This ensures that bondholders' voices do not go unheard. Debt covenants are the resulting contracts between bondholders and companies.
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Debt Covenant Definition
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A debt covenant is an agreement between a company and its creditors that compels a company to act within certain defined limits of behavior.
Purpose of Debt Covenants
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There are two main ways to make money from a company: buying its stock or buying its debt.
A stock can go up or down any day that the stock market is open. This means that stockholders could lose everything, but they are rewarded for taking that risk with the potential for much higher returns if a company outperforms.
A debt holder, on the other hand, cannot expect to earn more than the value of the bond: A $1,000 bond will never net an investor more than $1,000. However, if a company gets into financial trouble, a bondholder can wind up getting much less than the face value of the bond--as little as half or less, depending on the company's situation.
Therefore, stockholders and bondholders have a somewhat adversarial position, though both want a company to succeed. Stockholders want the company to take a certain amount of risk so they have the chance of seeing large returns. Bondholders want a company to be more conservative to ensure that they will get their loan repaid. Debt covenants are a bondholder's way of limiting the amount of risk a company can take, in hopes that its actions will not put it in financial danger.
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Common Covenants
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Common forms of debt covenants may prohibit behavior like issuing more debt: if a company racks up too much debt on its balance sheet, it could run out of money to pay its creditors and default. It may also require certain balance sheet conditions--keeping a certain amount of cash on hand, or having a certain ratio of debt to equity. A covenant can even force a company to sell assets to live up to its side of the bargain.
Breach of Covenants
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When a company does not live up to its debt covenant, it breaches the contract. In theory, such action would trigger the automatic payment to creditors, but in reality, many companies default because they are not in good financial health, and thus cannot pay. Therefore, breach of covenant usually means that the two parties renegotiate the terms of the debt, often calling for higher interest rates or other incentives for the bond holders to allow a company more time to pay. This is not beneficial for a company, because if it cannot reach an agreement with creditors, it can go bankrupt. Even if an agreement is reached, its reputation will suffer greatly, and it will have to borrow at more unfavorable terms in the future.
Other Names
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Debt covenants are also known as banking covenants or financial covenants. These are all the same instrument.
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References
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