Bond covenants are part of the legal documentation that makes up a bond, whether it is issued by a company or the government. They are usually intended to protect investors by providing some assurance on what the bond issuer will and won't do over the life of the bond. Because many companies are opting to issue bonds without covenants, some investors are moving toward other instruments such as asset-backed securities.
Bonds are security products that are similar to stocks because investors buy them hoping for a return on their money over time. However, a bond is a loan made to an entity, while a stock represents ownership equity in a company. Returns on a bond can come through periodic interest paid on the amount loaned or through selling a bond that has increased in value because of market changes.
An indenture is the document that spells out the agreement between a bond issuer and the bond holder. Within the indenture are items known as covenants, which specify what the issuing entity may or may not do during the life of the bond. As long as a bond has not matured, or reached the end of its agreed term and been fully paid back, the issuer is bound by these covenants.
Bond covenants can either be positive or negative. Positive bonds are also called protective bonds because they require the bond issuer to take certain actions, usually with the aim of protecting the investor. These actions may include carrying insurance, maintaining certain financial performance standards or providing financial statements. Negative covenants prevent the bond issuer from taking certain actions while the bond is active. Examples include selling the issuing company or merging it with another company.
Because companies may not want to be restricted from various actions by bond covenants, many have adopted the practice of issuing bonds without bond covenants. This may not create any problems for the person buying the bonds during times of prosperity, but it could present risks during economic downturns. For this reason, investors should verify exactly what bond covenants are included in the indenture note and carefully weigh a decision about buying a bond without these protections.
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