Bond Covenants

A bondholder has no vote and no board seat, so the only leverage they have over how a company behaves is written into the bond contract itself — the indenture — before the money changes hands. Those written restrictions are covenants.

Covenants split into two families. Affirmative covenants are things the borrower must do: pay interest on time, maintain insurance, deliver financial statements. Negative covenants are things the borrower is barred from doing without lender consent: taking on more debt past a set leverage ratio, paying large dividends, selling core assets, or letting other lenders jump ahead in priority. Negative covenants are where the real protection lives, because they stop management from quietly transferring value away from bondholders toward shareholders while the bond is still outstanding.

Worked example. Two otherwise identical five-year bonds from similar companies are issued at the same time. Bond A has a strict covenant capping total debt at 4x EBITDA and restricting dividends if leverage exceeds 3x. Bond B, a "covenant-lite" issue common in leveraged loans, has no such caps. If the market prices the protection at 75 basis points, Bond A might yield 6.00% and Bond B 6.75% for comparable underlying credit risk — the extra yield on B is compensation for the borrower's freedom to lever up or pay out cash to owners before Bond B matures.

The tradeoff cuts both ways: tight covenants protect the lender but can also force a technical default — a covenant breach — even when the borrower is still paying interest on time, simply because a balance-sheet ratio slipped past its limit.