Bond Covenant
Contractual conditions in a bond indenture that restrict issuer behavior to protect bondholders from increased risk after issuance.
What is Bond Covenant?
A bond covenant is a contractual provision embedded in a bond's indenture (the legal agreement between issuer and bondholders) that imposes obligations or restrictions on the issuer to protect bondholders. Affirmative (positive) covenants require the issuer to take certain actions—such as maintaining insurance, providing audited financial statements, and meeting minimum financial ratios. Negative (restrictive) covenants prohibit the issuer from actions that could harm bondholders—such as taking on additional debt beyond specified limits, paying excessive dividends, or selling core assets. Covenant violations constitute a default event, giving bondholders the right to accelerate repayment. Investment-grade bonds typically have fewer and looser covenants than high-yield bonds.
Example
A high-yield bond indenture includes a leverage covenant requiring the issuer to maintain a total debt-to-EBITDA ratio below 5.0x. When an economic downturn reduces EBITDA from $200 million to $120 million while total debt remains at $800 million, the ratio rises to 6.7x—breaching the covenant. Bondholders can then negotiate a waiver (often for a fee) or accelerate the debt, forcing immediate repayment.