Say why debt covenants exist and what they do
The idea
Covenants are contractual restrictions a borrower accepts in exchange for cheaper credit. Affirmative covenants require actions — maintaining insurance, supplying financial statements, keeping a ratio above a threshold. Negative covenants forbid them: additional borrowing beyond a limit, asset sales, dividends above a level. Their purpose is to restrain the risk-shifting incentive that leverage creates, since shareholders capture the upside of a gamble while lenders bear much of the downside. Breaching one usually triggers a default even when every payment has been made on time, which is why covenant headroom is monitored as closely as liquidity.
A practice question
What does a borrower receive in exchange for accepting covenants?
- A lower cost of debt — correct
- A longer maturity by lawWhy not: Maturity is negotiated, and nothing in law extends it in return for covenants.
- Exemption from interest paymentsWhy not: Interest is the price of the borrowing and is owed regardless of what else is agreed.
Restrictions reduce the lender's risk, and that reduction is priced. Covenants are the mechanism by which a borrower buys a cheaper coupon.
A harder one
Which is an example of a negative covenant?
- A requirement to supply audited accounts quarterlyWhy not: An affirmative covenant: it requires the borrower to do something rather than refrain from it.
- A restriction on paying dividends above a specified level — correct
- A requirement to maintain insurance on pledged assetsWhy not: Also affirmative, and among the most common obligations of that kind.
Negative covenants prohibit actions that would transfer value away from lenders. The other two are affirmative covenants, which require the borrower to do something.
The hardest tier
A company meets every interest payment but breaches a leverage covenant. What is the consequence?
- Nothing follows, since no payment has been missedWhy not: Covenant breach is itself an event of default in most agreements, whatever the payment record.
- The interest rate resets automatically to a statutory maximumWhy not: No statute does this. A margin ratchet may raise the rate, and only if the contract provides for it.
- It is typically an event of default, making the debt repayable — correct
Covenants exist to give lenders a say before a company reaches the point of missing payments. A breach is an early trigger by design, and it usually opens a renegotiation from a weak position.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →