Debt Covenant
A contractual condition in a loan agreement requiring the borrower to maintain specific financial ratios or behaviors.
What is Debt Covenant?
A debt covenant is a contractual clause in a loan or bond indenture agreement that imposes conditions on the borrower to protect the lender's interests. Affirmative covenants require the borrower to take certain actions—such as maintaining adequate insurance, providing regular financial statements, or keeping assets in good condition. Negative covenants restrict actions—such as taking on additional debt, paying excessive dividends, or selling key assets without lender approval. Financial covenants require the borrower to maintain specific metrics, such as a minimum interest coverage ratio, a maximum debt-to-EBITDA ratio, or a minimum current ratio. Violating a covenant constitutes an event of default, which can give lenders the right to accelerate repayment, raise interest rates, or seize collateral.
Example
A bank lends $50 million to a retail company with a covenant requiring the borrower to maintain an interest coverage ratio above 3.0x. When the company's EBIT falls during a recession, the coverage ratio drops to 2.5x—breaching the covenant. The bank can demand immediate repayment or renegotiate terms, typically extracting higher fees or tighter restrictions.