What is a covenant?
Short answer: A covenant is a promise in a loan agreement or bond document that requires the borrower to meet agreed financial or operating conditions.
Covenants protect lenders by creating early warning signals and control rights before a borrower misses a payment. For borrowers, they define the practical room to operate while debt is outstanding.
Common types of covenants
- Financial covenants: Metrics the borrower must maintain, such as debt service coverage, interest cover, leverage, minimum liquidity, or current ratio.
- Affirmative covenants: Actions the borrower must take, such as providing management accounts, keeping insurance in place, paying taxes, and maintaining permits.
- Negative covenants: Actions the borrower cannot take without consent, such as taking on more debt, selling material assets, paying dividends, or changing control.
Why covenants matter
A covenant package can be as important as the interest rate. It determines how much flexibility the company has if trading softens, working capital moves against plan, or an acquisition opportunity appears.