18 Sep 2013

Covenants

A covenant is a restriction placed on a borrower designed to afford protection to lenders. If a covenant is breached, the loan may have to be repaid early. There are two basic types of covenants.

Maintenance covenants would set minimum levels on financial indicators such as profitability, cash flow, liquidity and interest cover, and maximum levels on gearing.

Incurrence covenants would restrict a company in:
  •   Taking on more debt
  •   Payment of dividends or other distributions subject to certain criteria
  •   Sale or transfer of assets
  •   Extending guarantees
  •   Granting “negative pledges”
  •   Permitting change of control
The change of control clause has, in recent years, proved very contentious. Most bank loans contain such a clause whereas bonds, until the last few years, did not. In the event that a company would be acquired and the acquiror was financed in a very leveraged way, the bank loans would have to be refinanced immediately, whereas the bonds could become junk and investors would suffer significant losses. Examples of even a putative takeover having such a negative effect on bond prices are Marks & Spencer and J Sainsbury. 

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