Financial Education

Unlike equity investors, debtholders typically cannot receive more than the face value of their bonds. However, poor performance by the company could cause debtholders to receive less than face value. While equity investors benefit disproportionately when risky projects succeed, bondholders can suffer if they fail. Since owners have an incentive for management to take risks that may be costly to bondholders, bondholders typically require contractual limitations on that behavior. These limitations are known as covenants.

Common covenants include restrictions against issuing more debt, requiring that a minimum level of working capital be kept, limits on certain ratios such as interest coverage or debt/equity, assets to be used as collateral and even restrictions on how the borrowed funds may be used.

When covenants are violated, the bonds are said to be in default. At that time the issuer and bondholders must negotiate a new agreement, which could be as simple as the covenant being temporarily or permanently waived, to outright renegotiation or redemption of the debt. Typically a certain minimum number of bondholders will negotiate the new terms on behalf of all bondholders.

Equity investors should also be aware of the company’s bond covenants and monitor any ratios that could trigger default. A company forced to make significant concessions to bondholders could have serious consequences for the equity as well.

For more information, see all articles on: Fixed income investments, Investing in bonds

See also:

Current Portion of Debt, or Debt Maturing Within One Year

Accounting for Debt Retirement

Debt to Equity

Analyzing Convertible Debt

Restructured or Impaired Debt