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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