Covenant

A promise written into a bond contract that limits what the issuer may do while the debt is outstanding - additional borrowing, dividends, asset sales, or a minimum level of interest cover.

Example

A covenant capping total borrowings at a multiple of earnings forces a conversation with lenders before the multiple is breached, rather than after.

Important

Covenants matter only in the case where they are least pleasant to think about: the deteriorating issuer. A materially higher yield paired with materially weaker covenants is not extra return for the same thing.

Related terms

• Issuer — The borrower on the other side of a bond - a sovereign government, a state or municipality, a government agency or a company. The issuer owes the coupons and the par value.
• Credit risk — The risk that an issuer fails to make a contracted payment. It is the risk most associated with bonds and, for high-quality issuers, rarely the one that moves the price.
• Default — The failure of an issuer to meet a contracted obligation - a missed coupon, a missed principal repayment, or the breach of a term that permits creditors to demand repayment.
• Due diligence — The work of independently verifying the claims made about an investment before committing money to it - the documents, the counterparties, the registrations and the numbers.

Lessons that explain it

• Appraising one bond: three yields that disagree, and what the rating leaves out — A single bond has a coupon rate, a current yield and a yield to maturity, and they are three different numbers. The gap between the last of them and a government bond is the market's own estimate of what could go wrong. (13 min)
• A board seat can carry personal legal risk, especially when a company approaches insolvency — Directors can face personal liability for certain failures, and the risks often rise when a company is close to running out of money. Directors' and officers' insurance and indemnities reduce but do not remove that exposure. (11 min)
• Every instrument answers one question differently: what happens if it goes badly — Warrants give the right to buy shares at a set price. Venture debt is a loan that ranks ahead of equity and often comes with warrants. In a poor outcome, the order of claims decides who recovers anything. (11 min)
• Some companies can be funded without selling equity at all — Revenue-based financing, venture debt and grants provide capital without dilution, in exchange for repayment obligations or restrictions. They suit companies with predictable revenue more than pre-revenue ones. (11 min)
• You are the lender, so you inherit the lender's worst day — Private credit means lending money outside public bond markets - to companies, property projects or individuals - usually directly or through a platform or fund, with no easy way to sell the loan. (9 min)
• Appraising one loan: what backs it, how thin the cushion is, and who collects — Evaluating a loan means asking how the borrower repays, what happens if they cannot, how far collateral could fall before you lose money, and how reliable the lender or platform is at recovery. (13 min)

All 578 terms in the Investing glossary