3.3.2.1. Protective Covenants
Because the value of a bond depends on the financial strength of the issuing company, indentures usually include covenants to place limits on the issuer’s management of its company. A default or violation of any covenant can serve to alert investors of a potentially deteriorating situation. In that sense, covenants are a risk management tool for bondholders. Protective covenants require that the issuer take certain actions in case of default, while negative or restrictive covenants impose limitations on the issuer. Both serve to increase the market value of the bond and reduce its chance of default. Restrictive covenants also have value to the issuer because they allow bonds to be offered at a lower yield. A safer bond will have a lower yield.
Every bond indenture is different, but restrictive covenants may feature these general characteristics:
• Restriction on indebtedness. New borrowing by the issuer is limited past a given level and any new senior debt may be prohibited.
• Restriction on payments. A company’s cash outflows, dividend payments, acquisitions, and investments may be restricted to a certain percentage of its net income.
• Restriction on liens. A company’s ability to secure future debt with its assets may be restricted. Alternatively, unsecured bonds may automatically become se