What Is a Financial Covenant?

A financial covenant refers to certain conditions a borrower must fulfill throughout the loan term to prove their continued creditworthiness to the lender. These conditions are sometimes outlined as financial tests, such as meeting a certain interest coverage ratio. Lenders use covenants to protect their interests.

Definition and Examples of a Covenant

In the case of a loan, covenant requirements are conditions the borrower must regularly meet throughout the term to demonstrate their creditworthiness to the lender. Lenders frequently use certain financial tests that serve as indicators of the borrower’s repayment ability. Failure to meet these tests violates the covenant and constitutes loan default.

For example, let’s say a business owner secures a commercial loan from a lender. One of the covenants the lender requires is that the business owner maintains a minimum interest coverage ratio (the ratio of a firm’s cash flow to its loan interest payment). During the loan term, the business must maintain a minimum interest coverage ratio of 1.75 to 1. If the business owner fails to maintain this requirement, the covenant is violated and the lender has the right to call the loan.

How Does a Covenant Work?

Covenants are useful in mitigating the lender’s risk exposure. Covenant requirements protect their interests by creating requirements or restrictions on what the borrower can or can’t do. Should a borrower violate a covenant, such as not maintaining a certain interest coverage ratio or engaging in unpermitted business activities, it may constitute a loan default.

Examples of positive covenants include maintaining certain insurance policies or agreeing to on-site inspections by engineers and consultants. Negative covenants can restrict the borrower from incurring additional debt, offering financial assistance to another party, or engaging in business activities that are not considered characteristic of the business.

Some loan agreements may have a trigger acceleration clause. When a loan covenant is breached, this clause can enable the lender to demand immediate repayment from the borrower. Trigger acceleration clauses can be especially useful because they allow a lender to recoup some of the borrowed funds before the borrower’s financial situation deteriorates into potential bankruptcy.

There are some cases where the lender may choose to waive the covenant violation; instead, the lender may work with the borrower to renegotiate the loan terms. This can save the borrower from the financial burden of immediate repayment of the outstanding balance. The negotiations, however, can result in higher interest rates and stricter terms for the borrower.

Types of Covenants

Outside the lending industry, covenants can apply to contracts in other contexts, including:

• Employment
• Business acquisition
• Investing

Employment

Covenant not-to-competes are common covenants in employment contracts. This clause usually restricts an employee from using their current employer’s resources to benefit a future employer for a certain period. Employers use this to protect their business assets, such as client information and trade secrets.

Business Acquisition

Before acquiring another business, the buyer will usually request the company’s financial statements and other proprietary information. The seller will typically comply with this request, but only after the potential buyer agrees to a confidentiality covenant. Should the buyer back out of the transaction, they agree to return all confidential information to the seller.

Investing

Bondholders may require covenant protections that restrict the company from engaging in activities that could adversely affect repayment ability to its bondholders. Some covenants may put the bondholders’ interests over other creditors.

What It Means for Individual Investors

Investors should take note when investing in “covenant-lite” investment instruments such as high-yield bonds. When covenant requirements are minimal or absent, your risk exposure is increased. The frequency of covenant-lite bonds tends to increase when high-yield bonds are in high demand.

Notable Happenings

Covenant breaches can increase in correlation to declining economic conditions. During the 2020 recession, for example, there was an increase in the number of leveraged loan borrowers in violation of their covenant requirements.

As a result, more borrowers are seeking relief from their credit agreements. Specifically, the number of covenant-relief transactions in 2020 is 193—up from 186 in 2009, following the Great Recession.