Explain what a \"bond covenant\" in an indenture is and why it may be included.
ID: 2814340 • Letter: E
Question
Explain what a "bond covenant" in an indenture is and why it may be included. Explain the difference between an affirmative and a negative covenant. Categorize each of the following as affirmative or negative (of course briefly explaining why): a. limits on the issuer's leverage ration; b. a requirement to pay taxes when due; c. a statement of how the bond proceeds will be used; d. a prohibition on certain risky investments by the company; e. limits on the issuer's sale of corporate assets; f. a requirement to maintain the corporation's current lines of business.Explanation / Answer
bond covenant specifies the requirements/actions that are to be fulfilled by the borrowing firm which protects the lending firm from increased credit risk.
Affirmative Covenant: It is a type of covenant, also called a positive covenant , in which the borrower has to follow certain terms as specified by the lending firm . This type of covenant usually does not lead to restrictions on operating activities of the firm
Negative Covenant: This type of covenant often places restrictions on certain activities of the firm and stipulates actions that a firm is not allowed to do.
a) This is negative since a restriction is being placed due to which firm will have to limit itself from an excess amount of new debt
b) This is affirmative since this will not limit a firm’s activities
c) This is affirmative since this is a requirement of the bond holder
d) This is clearly negative since the firm will not be able to take up risky investments even if it provides a higher expected return
e) This is again clearly negative since there is a limit placed on sale of corporate assets
f) Since it is just a requirement which will not interfere with normal operations of the borrower, it is affirmative
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