In publicly-owned companies that issue bonds, management answers to stockholders. When an investor buys a corporate bond, risk is accepted based on the firm's creditworthiness. However, since bondholders have no direct control over the actions of management, bond contracts may contain provisions known as protective covenants. These clauses aim to protect the rights of bondholders and provide bond investors with some influence on the actions of the firm's management.
A protective covenant is used in a bond indenture, a legal contract between the issuer and bondholders, the details of which vary from bond issue to issue and from company to company. Protective covenants generally include provisions that restrict specific financial policies of the firm. For example, a bond covenant may prohibit the company from paying shareholders dividends above a specified amount, with the intention of limiting the amount of assets the company's management can distribute. Covenants also may list specific actions that management will take to protect bondholders; for example, use assets to purchase assets of equal value or redeem the bonds.
Protective covenants in bonds may prohibit management from issuing new debt that carries a priority over the current issue. For example, a firm may have a number of bond issues in circulation, some with seniority over others. Should the firm be forced to liquidate or have limited assets with which to service debt obligations, senior bond issues would be serviced first. If a particular bond issue carries a protective covenant restricting this action, no other issues will carry priority of payment over the ones with a covenant prohibiting such action.
A bond covenant also may restrict the total amount of debt a firm can take on. The intended effect of such a provision is to ensure the firm's financial stability and protect the bondholders' claims on assets. During the mergers and acquisitions process, a firm may restructure its debt or the company may restructure its management organization. Some protective covenants in bond contracts specifically give bondholders a right to redeem bonds prior to the official maturity date should the original company of issue undergo a merger with, or acquisition by, another firm.
Trends in Covenants
Not all corporate bond contracts carry protective covenants. Trends since the 1980s have been toward less and less protective covenant clauses in bond contracts without objection from bond investors. Studies have also shown that bond investors tend not to read a bond indenture in its entirety but simply review the summary in the prospectus of the investment.