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Bonding covenants specify how covenants are enforced
9 Covenants (cont.)
Asset covenants state what lenders get in default
– Senior bonds have priority in bankruptcy
– Junior bonds have subordinated claims
– Secured bonds (specific assets are pledged)
– Restrictions on acquisitions
Dividend covenants prevent managers from liquidating
the firm, paying out the cash to shareholders, and leave
Financing covenants restrict new debt issues that would
dilute the claim of existing debt holders (unless the firm
is financially strong)
10 Covenants and Financial Ratios
Asset and financing covenants are generally
written in terms of financial ratios
Minimum net working capital or net worth
Minimum interest coverage ratio
Minimum ratio of fixed assets to total debt
When the firm cannot meet a financial ratio
condition, it is technically in default even if it has
maid the required payments to lenders
11 Covenants Affecting the Pattern of Payoffs
Sinking funds require that a certain portion of the
bonds are retired before maturity.
A typical sinking fund on a 30 year bond might
ensure that 25% of the bonds are retired between
years 10 and 20.
The firm makes payments to the trustee, who then
repurchases randomly chosen bonds.
Callable bonds give firms the right to redeem the
bond before maturity at a stated price.
Useful if interest rates are expected to fall.
12 Covenants affecting the pattern of payoffs
Convertible bonds give the holder the right to exchange the
bond for common stock of the company.
The convertible debt contract must specify:
– The security issuable upon conversion (stock in general)
– Duration of the conversion period – when can be converted
– Conversion price at which the stock can be acquired
– Anti-dilution provisions: protect the conversion privilege against
stock splits, stock dividends, or issuance of other convertibles
– Other details Useful when shareholder-bondholder conflicts make straight
debt issues costly (more on this on capital structure section)
13 Bonding Covenants
Bonding covenants specify a bonding mechanism – a
provision ensuring that the borrower will uphold the
covenants in the contract
They are intended to reduce monitoring costs to debt
holders (and thus bond yields)
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- Spring '13