Covenants define the credit quality of a borrower that the borrower must maintain over the life of a loan. If loans are made on demand, there is no particular need for covenants since the lender could just ask for its money back on the slightest concern or whim. Loans made for a term require a mechanism to allow the lender to intervene if the borrower’s credit quality falls below a certain level. Conceding covenants (and they do surrender some element of control to the lender) is the price that borrowers pay for enjoying term loans.
There are two types of covenants in conventional loan documents:
Financial covenants can take several forms:
Some particular debt structures will have their own covenants. For example, project finance and infrastructure arrangements (which are typically long term) use a loan life coverage ratio, which discounts future cash flows to the project.
There are many other possible provisions, but the above two types form the basis of covenants. Breach of a covenant will lead to a default event, which in turn allows a lender to ask for repayment of the loan.
Generally, the stronger the borrower, the less control is surrendered to lenders, and covenants are fewer and weaker. The investment-grade/sub-investment-grade boundary is often seen as a dividing line between low and significant surrender of control. Bank loans usually have more covenants than bonds, except in the case of bonds for sub-investment-grade borrowers, ie high-yield bonds.
The covenants described so far are examples of ‘maintenance’ covenants, meaning that the borrower must maintain or comply with the limits set by the covenants. An alternative approach is seen with ‘incurrence’ covenants, which work in a different way. Here, if a borrower wants to undertake a certain activity, such as make a dividend payment, sell some assets, merge or reorganise in some way, or take on further debt, it can do so only if it passes a certain test/s. One test might be a debt/EBITDA ratio, which allows more debt to be taken on if a ratio is passed (leading to the concept of ratio debt). These types of covenants are often referred to as ‘cov-lite’ and are associated with high-yield bonds.
While the usual focus of compliance, or the process of ensuring that covenant tests are passed, is around financial covenants, there are many instances of borrowers taking steps to refinance because of a breach in a negative pledge clause caused by some corporate activity. Compliance monitoring should therefore be around both financial and non-financial covenants.
Treasurers must:
Will Spinney is associate director of education at the ACT
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