Loan Covenant

Covenants give lenders some control and early warning if a borrower's financial health deteriorates. They are especially common in business loans and bonds.

Affirmative or positive covenants require the borrower to take certain actions, such as providing regular financial statements, maintaining insurance and paying taxes. Negative covenants restrict actions, such as taking on more debt, paying large dividends, selling key assets or making major acquisitions without the lender's permission.

Financial covenants require the borrower to meet specific financial ratios. For example, a loan might require a company to keep its net debt below three times its annual earnings before interest, taxes, depreciation and amortization, and its earnings at least four times its interest payments.

If a borrower breaches a covenant, the lender may have the right to demand immediate repayment, charge a higher interest rate or renegotiate the terms. In practice, lenders often agree a waiver or amendment, sometimes for a fee, rather than forcing a default. Loans with fewer protective covenants are sometimes called covenant-lite.