Covenant — The Dollar Dictionary

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Finance

Covenant

A condition included in a loan or bond agreement that requires the borrower to maintain certain financial ratios or behaviors — or restricts certain actions — to protect the lender.

There are two types: affirmative covenants (things you must do — maintain insurance, provide quarterly financial statements, maintain minimum cash balances) and negative covenants (things you cannot do — take on additional debt, sell major assets, pay excessive dividends, make acquisitions above a certain size). Together, they protect the lender's position throughout the life of the loan.

Covenant-lite loans (with fewer or looser covenants) became common during the low-interest-rate era of 2010-2021, when abundant capital gave borrowers negotiating power. These loans give companies more operational freedom but reduce lender protection — a trade-off that becomes very visible when economic conditions deteriorate and there are no triggers forcing early intervention.

Loan covenants are the fine print rules a lender writes into your loan contract. Think of them like house rules when you borrow a car: don't take it out of state, keep it under 5,000 miles, don't let anyone else drive. Break the rules and the lender can demand immediate repayment — regardless of whether you're making your regular payments on time.

Real world: When a private equity firm takes on significant debt to fund an acquisition, lenders typically require covenants like: 'total debt cannot exceed 5x EBITDA' and 'interest coverage ratio must stay above 2x.' If a recession hits and EBITDA falls, the company might breach these covenants — triggering a 'technical default' even though no payment has been missed. Lenders then have enormous leverage to renegotiate terms.

💡 Loan covenants are the rules that come with borrowed money — they protect lenders but constrain borrowers, and breaching them can trigger a crisis even when every scheduled payment has been made.

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