Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Restrictive Covenant

What it is:

A restrictive covenant is a promise a company makes to not exceed certain financial ratios or not conduct certain activities, usually in return for a loan or bond issue.
   

How it works (Example):

Let’s assume Company XYZ wants to borrow $10 million from Bank ABC. The loan agreement contains restrictive covenants that limit Company XYZ to $0.10 per share in dividends per year and prevent it from issuing additional debt without Bank ABC’s consent.

Restrictive covenants can exist in employment agreements and even merger or acquisition agreements, but they are most common in lending agreements and bond indentures. Covenants, in general, can be financial or operational in nature.

The lending agreement or indenture in which the covenant appears will also provide detailed formulas to be used to calculate the ratios and limits on restrictive covenants. It is important to note that in many cases these formulas do not conform to generally accepted accounting principals (GAAP). For example, the restrictive covenant may include leases in a debt-limit calculation, or it may consider capital leases as an expense. As a result, it is very important that borrowers scrutinize covenants before borrowing.

Why it Matters:

Lenders attach restrictive covenants to bond issues and loans as a way to force the borrower to operate in a financially prudent manner that most ensures it will repay the debt. Issuers, on the other hand, usually negotiate the most flexible covenants they can so they have the freedom to make decisions and take risks that might ultimately benefit the lenders and the shareholders. Thus, the more restrictive covenants a bond issue has, the lower the interest rate on those bonds tends to be.

Violating a restrictive covenant can trigger a technical default. This means that although the issuer is making interest and principal payments on time, it is not operating within the agreed-upon guidelines and is thus increasing the risk of nonpayment in the eyes of the lender or bondholders. Often borrowers have a certain amount of time to remedy (or "cure") the technical default (for example, the borrower must lower its debt-to-equity ratio within 30 days), but technical defaults often lower the borrower’s credit rating and stock price.

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