A bond or loan is a contract, and that contract is where the creditor's real power lives: the indenture for a bond, the credit agreement for a loan. Financial ratios describe the credit; covenants govern it. And here is the point most equity analysts miss: covenants transfer control long before insolvency does. A company that breaches a maintenance covenant is not bankrupt, but it is now at the mercy of its lenders, who can waive the breach (for a fee and tighter terms), refuse to (forcing repayment the company cannot make), or extract equity-like concessions. The equity holder who ignored the covenant wakes up to find the lenders, not management, deciding the company's future.
The two great families.
- Maintenance covenants are tested periodically (usually quarterly), regardless of whether the company does anything. "Net leverage must not exceed 4.5× at each quarter-end; interest coverage must stay above 2.5×." They are the hallmark of bank loans and leveraged loans, and they are the tightest leash in finance: a company whose EBITDA merely drifts down into breach is in default without having taken a single action. This is why maintenance covenants are an early-warning system: they trip on deterioration, not on catastrophe.
- Incurrence covenants are tested only when the company takes a specified action: incurring new debt, paying a dividend, making an acquisition. "The company may incur additional debt only if pro-forma net leverage is below 6.0×." If the company does nothing, the covenant is never tested, even as leverage climbs from deteriorating EBITDA. Incurrence covenants are the hallmark of high-yield bonds, and they are looser by design: the bondholder accepts less control in exchange for yield and a longer maturity. The rise of "cov-lite" leveraged loans (loans with incurrence-style, not maintenance, covenants) since the 2010s has been the single biggest structural shift in credit risk, because it removed the early-warning tripwire from a huge slice of the market. Verify the current prevalence.
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What are negative covenants and cross-default clauses?
The core negative covenants (the "thou shalt nots," present in some form in most indentures):
- Negative pledge: the company may not grant liens (security) to other lenders without equally securing this one. Protects an unsecured creditor from being structurally leapfrogged.
- Restricted payments (RP): limits dividends, buybacks, and investments in non-guarantor entities. This is the covenant that stops cash leaking to equity holders or to a promoter ecosystem, and it is the credit-contract answer to the leak that felled CG Power and Zee. RP capacity is usually a basket: a fixed amount plus a "builder basket" that grows with retained earnings.
- Debt incurrence: caps additional debt, via the incurrence ratio test above plus permitted-debt baskets.
- Asset-sale covenant: requires sale proceeds to repay debt or be reinvested, so the company cannot sell the crown jewels and dividend out the cash.
- Change-of-control put: lets bondholders demand repayment at (typically) 101 if control changes, so they are not left lending to a new, unknown owner.
Cross-default and cross-acceleration are the connective tissue: a default on one instrument triggers default (or the right to accelerate) on the others, so a company cannot quietly default on one loan while servicing the rest. This is why a single covenant breach can bring down an entire capital structure at once. It is also why the analyst maps the whole debt stack's covenants, not just the instrument in front of them.
How do debt covenants work in India?
India specifics. Indian debentures are governed by SEBI's issue-and-listing regulations and a mandatory debenture trustee who acts for holders; secured debentures carry a security cover requirement (e.g., asset cover of 1.0–1.25× the outstanding, tested and certified) and often a DSRA (debt-service reserve account: a segregated cash buffer of one or two quarters' debt service). Bank consortia enforce drawing power against working-capital limits. And, as PC Jeweller learned, lenders refusing consent to a corporate action is itself a public credit signal. Charges are registered with the Registrar of Companies and disclosed; CARO requires the auditor to comment on defaults and on the use of borrowed funds. Read them. (Specifics evolve, so check against current SEBI LODR/NCS regulations.)