Fixed-Income Features: Bond Covenants

Bill N. Vestir is in the process of purchasing a bond from Exotic Tours. This is a complex bond with a __bond indenture__ of over 200 pages. Now Bill is focused on the bond __covenants__. Covenants are just a set of rules that are spelled out in the indenture which are legally binding. They are part of the contract. They are agreed to between Bill and Exotic tours at the time of issue.

The indenture contains both __affirmative covenants__ and __negative covenants__. Affirmative covenants are also called __positive covenants__, and state what the issuer will do. The positive covenants in the Exotic Tours issue are fairly standard for positive covenants. Exotic Tours is promising what the money will be used for, that they will obey the law, pay their taxes, stay insured, and pay back the bond.

Does it sound like these affirmative covenants are very binding for Exotic Tours?

That's right! The affirmative covenants just spell out the things they are already doing to stay in business. Everyone needs minimal insurance, and to pay taxes and obey the law. Capital will be spent on the best projects. So there's really nothing worth worrying about here.

No, even without the bond issue, they would use insurance, pay taxes, and have to obey the law.

No, there's nothing on the list of affirmative covenants that threatens the business at all.

On the other hand, negative covenants can be quite binding for the firm. These are really assurances that protect bondholders, so think about the things that bondholders don't want: more firm debt to dilute their claim, cash leaving the firm, or anything that adds risk. Exotic Tours took care of a lot of these worries with a series of negative covenants. There is a _restriction on debt_ listed that limits Exotic Tours' debt ratios. There is also a _negative pledge_ that any additional debt won't have a more senior status to what Bill is purchasing. That's good.

In fact, without both of those, what risk would Bill have in holding his bond?

Exactly! As new, more senior debt is added ahead of Bill's bond, he keeps getting pushed back further and further in line. This definitely wouldn't be the same deal Bill signed up for.

No, while it's true the firm could issue a lot more debt without those covenants, this added risk and more junior claim of Bill's bond would make his bond's yield higher, not lower. This is because the price of his bond would fall.

No, new equity isn't a problem. Equity never has a prior claim to assets, and adding equity would lower debt ratios.

Exotic Tours also has a negative covenant of _restriction on prior claims_ so they can't take firm assets and pledge them as collateral for someone else. That's good, since Bill's claim is on general firm assets. There are _restrictions on distributions_ to shareholders in the indenture as well, limiting what they can pay out. So they can't turn around and issue a 90% stock dividend or something crazy like that to steal the firm's assets for owners. They have _restrictions on asset disposal_ so they can't sell off the firm in chunks, and _restrictions on investments_ so management won't engage in new, risky projects Bill didn't know about before buying his bond.

The stockholders don't like the investment restrictions. "Why would you want to stop the firm from investing in projects that could double firm profits?" they ask Bill. What is a good answer?

No, this wouldn't be true of Bill and the other bondholders. They care about profits, as that's how Exotic Tours will pay them back.

Yes! Doubling profits does nothing for the bondholders. They just want stable, safe profits. That's how they will get paid back. Added risk is not good for their goals.

No, bondholders are still first in line for cash flows. Higher profits don't reduce their claim at all, and would actually make the bonds safer investments.

To summarize this discussion: [[summary]]

There might also be a negative covenant against mergers and acquisitions, or any number of other things. A __pari passu__ ("equal footing") clause is common, meaning that new debt has the same seniority as existing debt. Or a __cross-default__ clause basically says, "if you default to another debtholder, then you are defaulting to me as well." This isn't an exhaustive list. The common theme here is negative covenants greatly restrict the business from doing certain things which harm the claims of bondholders. They _do_ want their money back!

Yes, these are going to cripple their operations

Sort of, yes. If it wasn't for the bond issue, most things on this list wouldn't be done

No, this listing is basically the things they would be doing anyway

The company could simply place newer bondholders ahead of Bill, making his bond less valuable

The company could issue a lot of new debt, making Bill's bond yield lower

The company could issue new equity with a senior claim on firm assets

"Because I don't care about profits at all."

"Because I don't care about doubling profits, and that would add risk."

"Because higher profits generally give bondholders less claim to firm assets."

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