affirmative covenants and negative covenants

The legal contract between the bond issuer (borrower) and bondholders (lenders) is called a trust deed, and in the United States and Canada, it is also often referred to as the bond indenture. The indenture defines the obligations of and restrictions on the borrower and forms the basis for all future transactions between the bondholder and the issuer.

The provisions in the bond indenture are known as covenants and include both negative covenants (prohibitions on the borrower) and affirmative covenants (actions the borrower promises to perform).

Negative covenants

Negative covenants include restrictions on asset sales (the company can’t sell assets that have been pledged as collateral), negative pledge of collateral (the company can’t claim that the same assets back several debt issues simultaneously), and restrictions on additional borrowings (the company can’t borrow additional money unless certain financial conditions are met).

Negative covenants serve to protect the interests of bondholders and prevent the issuing firm from taking actions that would increase the risk of default. At the same time, the covenants must not be so restrictive that they prevent the firm from taking advantage of opportunities that arise or responding appropriately to changing business circumstances.

Affirmative covenants

Affirmative covenants do not typically restrict the operating decisions of the issuer. Common affirmative covenants are to make timely interest and principal payments to bondholders, to insure and maintain assets, and to comply with applicable laws and regulations.

Two examples of affirmative covenants are cross-default and pari passu provisions. A crossdefault clause states that if the issuer defaults on any other debt obligation, they will also be considered in default on this bond. A pari passu clause states that this bond will have the same priority of claims as the issuer’s other senior debt issues.