What Are Debt Covenants?
- Debt covenants arise because investors want as little risk as possible from their bonds. Bonds cannot easily rise in value except on the secondary market, but if the business fails they can lose money or be lost altogether. In order to prevent this, or at least make the loss of the security more manageable, investors as a whole may want a debt covenant. Essentially, this covenant binds a business to specific types of behavior while the bonds are held by the investors. For instance, a covenant may require the business to not raise any further funds through debt, or keep enough money to manage the business without spending it all in reckless investment.
- When a business refuses to pay a bond, typically because of financial problems, it is known as a default on the loan. This default breaks the debt covenant. In some cases the covenant may mention specific conditions that the business must meet if it defaults. The bondholders may also meet with representatives from the business and work out a new agreement, possibly allowing the covenant to be temporarily suspended or creating new conditions to protect investors.
- One of the key advantages of a debt covenant is the ability of the business to raise funds. Investors will be much more willing to buy bonds quickly and raise the money that the business needs. Investors will also receive increased security from the covenant, since it helps the business stay stable and provides information to the bondholders about how the business operates and what can be expected.
- The debt covenant can influence many of the actions of the business and may limit how the business wants to invest or the risks it wants to take. Sometimes they can give bondholders too much power over the company by concession. Also, a broken covenant affects not only debtholders like those owning bonds, but investors who own stock also pay close attention to the covenant. If it is broken, the company can also lose money through equity.
