Promises made between parties come in many different forms and shapes. On the playground children make “pinky swears” to keep a secret or to share toys or sweets based on some agreeable outcome; husbands and wives on their wedding day promise a long, but very “doable” list of things; advisors promise, among other things, to keep the clients’ best interest at heart; the issuer promises, again among other things, to repay bondholders and the list continues. We continuously enter into some sort of contractual agreement, one way or another, with different terms and conditions. We will be exploring some of the agreements that can be made between bond issuers and bondholders in greater detail.

Bond Covenants

These can be defined as legally binding agreements or “promises” made between the bond issuer and bond holder. The covenants outline the terms and conditions of the bond. The covenants will clearly outline the rights of the parties involved and the restrictions, if any, on the issuer. The covenants are designed to protect the interest of both the bondholder and the issuer.

There can be two types of covenants, negative or positive. Positive covenants require the issuer to meet specific requirements while negative covenants prohibit the issuer from performing or undertaking a predetermined set of activities. Let’s examine examples of what these promises entail.

Positive Covenants

Some examples of positive covenants include:

– Stipulations on the amount of liquidity i.e. cash or near liquid assets that the Issuer must put aside to repay investors the full principal amount of the bond upon maturity.

– The issuer may agree to have casualty insurance (coverage for negligent acts or omissions).

– The issuer can agree to submit audited financials or periodic reports to the investors.

– The issuer may be required to provide the bondholders with full disclosure about its business activities and performance as it is requested

The issuer generally has an obligation to uphold and fulfil its “promises” to the bondholders.

Negative Covenants

In simple terms, negative covenants are promises NOT to do certain things. Some of the conditions may include but are not restricted to the following:

– Restrictions on the amount of earnings paid out in the form of dividends to shareholders

– The issuer may also be restricted from issuing other bonds with higher interest rates or from issuing other debt until the bond matures.

– There may be requirements to maintain specific financial ratios r. This covenant would prevent the borrower from going above or below a specific set of financial ratios (such as the debt to equity ratio, or the interest coverage ratio for example).

– The issuer may be prohibited from passing off their obligations reagrding the debt to another party

It is important for bondholders to know and understand what the bond covenants are. Should the issuer break or violate one of the stipulated terms, it could automatically result in a default. In other words despite the fact that interest/coupon payments are paid in a timely fashion, if the issuer is not operating within the predetermined guidelines there could be a technical default. If a technical default takes place this lowers the issuer’s credit rating and makes it more difficult and expensive for them to re-issue new bonds in the future.

Dian Blackwood is a Manager, personal financial planning with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: dianb@sterlingasset.net.jm