Discuss what type of covenants might be attached to bonds? (3 marks)
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Covenants to bondholders limit the scope of shareholders / managers to confiscate wealth from bondholders for themselves. Such covenants would include agreements to refrain from, (a negative covenant) certain activities or to engage in certain activities (a positive covenant)
Types of bond covenant include:
- Regularly provide bondholders with audited statement of the firm’s financial position and any material changes to it, (a bonding covenant).
- Not disposing / selling off the assets of the company, (an asset covenant),
- Not subordinating their existing debt by issuing new debt or borrowing additional funds that rank above claims by existing bondholders if the firm was in financial distress and able to meet all its financial commitments, (a financial covenant),
- Not paying out large dividends to themselves (or engaging in a share repurchase scheme), (a dividend covenant) and / or ensuring that a sufficient levels of profit are reinvested back into the firm to finance future growth, (a reinvested covenant)
- Limit the values for key financial ratios in the firm, e.g. a minimum ratio of tangible assets total debt, interest cover, gearing level, net working capital etc., (financial ratio covenants),
- Preventing the firm from engaging in merger and takeover activities (a merger covenant). (Any 3 points)