Maintenance vs Incurrence Covenants
A maintenance covenant is tested every quarter whether or not the borrower does anything; an incurrence covenant only bites when the borrower tries to take a specific new action — and that difference changes how much protection lenders actually get.
Prerequisites: The Leverage and Coverage Ratios Lenders Use
Every loan agreement or bond indenture contains covenants — promises the borrower makes to protect the lender. But covenants come in two structurally different flavors, and the difference matters enormously for how much protection a lender actually has: a maintenance covenant is tested continuously, whether the borrower does anything or not; an incurrence covenant only gets tested when the borrower actively tries to do something the covenant restricts.
Maintenance covenants act like a smoke alarm that checks the room every quarter regardless of what's happening. Incurrence covenants act like a lock that only matters if someone tries to open a specific door. A company can quietly deteriorate for years without ever tripping an incurrence covenant, because deterioration on its own isn't a restricted action.
How each one actually works
A typical maintenance covenant requires, say, a leverage ratio (debt/EBITDA) to stay below 5.0x, tested every quarter regardless of what the company is doing. If EBITDA falls and the ratio drifts to 5.3x, the company is in default the moment that quarter's financials are reported — even if it hasn't borrowed a single new dollar or taken any new action at all. This gives lenders an early warning and a seat at the table to renegotiate terms well before a company actually runs out of cash.
An incurrence covenant, by contrast, only tests the same 5.0x ratio at the moment the company tries to do something specific — issue new debt, pay a big dividend, make an acquisition. If the company's leverage organically drifts to 5.3x through weakening earnings alone, nothing is triggered, because the company hasn't incurred anything new. The covenant only bites if management actively tries to add debt or cash out shareholders while already over the limit.
Worked example
A leveraged loan carries a 5.0x maintenance covenant, tested quarterly. A high-yield bond issued by the same company at the same time carries only a 5.0x incurrence-based debt test. Over two years, the company's EBITDA falls and its leverage rises from 4.0x to 5.8x purely from earnings erosion, with no new borrowing.
- Under the loan's maintenance covenant, the company is in technical default the first quarter leverage crosses 5.0x, and must negotiate a waiver or amendment with its bank lenders immediately.
- Under the bond's incurrence covenant, nothing has happened — the company hasn't tried to issue new debt or pay a dividend, so the 5.8x ratio, however uncomfortable, breaches nothing. Bondholders have no contractual trigger to act on until the company actually tries to take a restricted action.
What this means in practice
Bank loans have traditionally carried maintenance covenants because banks want an early-warning trigger and ongoing leverage over a struggling borrower; high-yield bonds have traditionally relied on incurrence covenants because bondholders are more numerous and harder to coordinate for frequent renegotiation. Over the past two decades, competitive pressure has pushed many leveraged loans toward "covenant-lite" structures that drop maintenance tests entirely, shifting loan investors toward the weaker, incurrence-only protection bond investors have long had to live with.
The absence of a maintenance covenant does not mean a company is safe — it means the lender only finds out about deterioration when the company chooses to act, or when it eventually can't pay. Don't read a clean maintenance-covenant test as good news about the underlying credit; check the actual leverage and coverage trend independently.
Further reading
- Fabozzi, Bond Markets, Analysis, and Strategies (ch. on covenants)
- Moody's, 'Covenant Quality Indicators'