Understanding bond and loan covenants

Understanding bond and loan covenants is essential for anyone involved in credit analysis, lending, or investment. These covenants serve as the primary means by which lenders and investors protect their interests, providing contractual guardrails that can significantly impact both risk and value in debt transactions. In today’s market environment—where deal structures are increasingly complex and covenant protections continue to evolve—having a firm grasp of these provisions is more important than ever.

This report summarizes the key insights from the webinar ‘Covenants 101: Decoding Bond and Loan Covenants’, where experts Scott Josefsberg and Ian Feng from Covenant Review demystified the core differences between bonds and loans, the role of covenants, and the function of major covenant types. You can watch the full webinar here.

Key takeaways

• Independence of covenants: Each covenant is independent; a transaction must be permitted under every relevant covenant.

• Bonds vs. loans: Bonds are more freely transferable and often have looser covenants, though this gap is narrowing. Loans may provide stricter lender protections.

• Restricted payments: The RP covenant is central to preserving value within the restricted group. The definition of what constitutes a restricted payment and the entities included in the restricted group are critical.

• Change of control: Bonds grant a put right at 101% on a change of control, whereas loans treat it as an event of default.

• Asset sales: Bonds and loans restrict asset sales, but proceeds are handled differently—redemption offers in bonds versus mandatory prepayments in loans.

• Customization and flexibility: The details of baskets and carve-outs can vary significantly and may be tailored extensively in negotiation. Carve –outs are separate and cumulative.

• Market trends: There is a trend toward convergence, with loan covenants increasingly resembling those in bonds, though nuances remain.

Key differences between bonds and loans

Bonds and loans, while both fundamental instruments in corporate finance, differ in critical ways. Bonds are securities, typically freely transferable, meaning issuers cannot control who holds their bonds. Conversely, loans are not securities and may involve restrictions on transfer, such as blacklists or whitelists.

Bonds are not subject to the same pro rata treatment rules governing loans—a distinction highlighted in recent liability management transactions.

Additionally, bonds tend to offer robust call protection, requiring a call premium for early repayment, while loans generally allow more flexible prepayment at par.

Furthermore, bonds usually have fixed-rate coupons, whereas loans are typically floating rate instruments.

Historically, bonds were designed as junior debt and featured looser covenants, but the rise of secured bonds has blurred these distinctions. Still, in many cases, bond covenants remain less stringent than those in loans.

What are covenants?

Covenants are promises made by a company to do or not do certain things. There are two main types: affirmative covenants (promises to do something) and negative covenants (promises not to do something). Unlike equity holders, creditors are not protected by fiduciary duties, so covenants provide vital contractual protections.

Negative covenants may include limitations on the incurrence of debt, the creation of liens, making restricted payments, change of control events, and asset sales.

Importantly, all covenants operate independently: a transaction permitted under one may not be permitted under another. This independence requires thorough analysis of each transaction against all relevant covenants.

What is a debt covenant?

Debt covenants limit the amount and types of future debt a company and its subsidiaries can incur. Typically, there is a broad prohibition at the outset, which is then qualified by a series of carve-outs or exceptions known as “baskets.” These baskets allow for certain types of debt—such as credit facilities, general debt, or subordinated debt—subject to set limits. The specifics of what constitutes debt are defined in the agreement and need to be carefully checked.

What is a liens covenant?

Liens covenants restrict the ability of a company to secure debt with its assets. It can limit the amount of debt that may be effectively senior to an unsecured bonds and the amount of new debt that would dilute the collateral for a secured loan or bond.

Carve-outs from the liens covenant are called “permitted liens” and are often cross-referenced to the debt covenant’s baskets. For example, a permitted lien might allow security for any debt incurred under a specific basket in the debt covenant.

There are usually general liens baskets and sometimes specific carve-outs, such as those based on a secured leverage ratio. All carve-outs are cumulative, and a company may rely on multiple baskets.

What is a restricted payments covenant?

The restricted payments (RP) covenant aims to prevent a company from transferring value out of the “restricted group” of entities, thereby preserving value for creditors. In high yield bonds, the RP covenant typically covers:

• Dividends on equity

• Stock repurchases

• Prepayments of certain junior debt

• Investments in entities outside the restricted group

The focus is on limiting dividends, buybacks, and other transfers of value outside the restricted group, including to unrestricted subsidiaries or holding companies.

In loans, “restricted payments” often refer only to dividends and stock repurchases, with other types of value transfers (investments, junior debt repayments) addressed in separate covenants. This approach achieves the same protective effect, though through different drafting. The concept of the “restricted group” is crucial, as only entities within this group are subject to these limitations, and their financials are counted for leverage calculations.

What is a change of control covenant?

Change of control provisions differ significantly between bonds and loans. In high yield bonds, a change of control typically gives bondholders a put right to sell their bonds back to the company at a small premium (101%). This right protects investors who may have invested based on confidence in the company’s management or ownership.

The definition of a change of control is built around “triggers,” the most important of which is a change in the acquisition of beneficial ownership of majority voting control by a non-permitted holder.

In loans, a change of control is usually an event of default, requiring immediate repayment at par unless the loan agreement is amended.

For syndicated loans, the trigger for change of control can shift if the company has gone public, often lowering the ownership threshold that constitutes a change of control. Notably, initial public offerings almost never trigger a change of control, rather they just change what the trigger looks like under change of control.

What is the asset sales covenant?

Asset sales covenants restrict a company’s ability to transfer assets to another party. Both bonds and loans typically include a general basket that allows asset sales if they meet certain requirements—most notably, that the sale is for at least fair market value and that a set percentage (commonly 75%) of the proceeds is in cash. However, what differs is the treatment of proceeds:

• In bonds, an asset sale typically triggers a par offer to redeem the bonds.

• In loans, proceeds are typically subject to a mandatory prepayment (asset sale sweep), requiring the cash to be used to pay down the loan, sometimes with a right to reinvest in the business instead.

Careful drafting is crucial to ensure that the provisions across different instruments work together and that proceeds flow as intended.

To explore further research and detailed insights on bond and loan covenants, please visit Covenant Review, where you can access expert analysis and request a trial for in-depth covenant coverage.

For credit professionals seeking additional training, explore the Global Credit Certificate, and other courses available from the Global Institute of Credit Professionals.