What Is Bond & Sukuk Covenant and Why Is It Important?

A bond covenant is a legally binding term of agreement between a bond issuer and a bondholder or investor. The covenant main function is to protect the interest of both the bond holder and issuer. The bond or sukuk Principal Term & Condition (“PTC”) document will have the detail on the covenant that the issuer will have to follow.

You can see the company PTC using steps below:

The PTC is a very important document that all investor need to read and go through as it summarizes the information on the sukuk and its issuer. We will discuss in more detail on PTC maybe on a later article but for now let’s focus on covenant.
If you scroll down and search covenant in the document you, you will find that Issuer of this sukuk will have to adhere to the positive covenant, negative covenant and financial covenant throughout the lifetime of this sukuk. So, what is the difference between these covenants?
 
 
Positive Covenant
Positive covenant is the obligation that the issuer will have to adhere through out the bond life time. Example in Al-Aqar positive covenant are:

 
Negative Covenant
Negative covenant is the issuer promise not to do something through out the bond or sukuk lifetime. Example in Al-Aqar negative covenant are:

 
Financial Covenant
Financial covenant on the other hand normally is the financial ratio that issuer have to maintain throughout the bond or sukuk lifetime. Example in Al-Aqar financial covenant are required to maintain:

 
 
When an issuer fails to comply or violate any of the item in the covenant, the bond will consider to be in technical default. This mean that even if the issuer is paying its interest and principal payment on time, it is not operating as agreed in the covenant which increase its risk of default on possible downgrading of its rating. However, depending on the term, investor may allow some time for issuer to improve but it will still negatively impact the rating or bond price.


WHY IS IT IMPORTANT?
Bondholder need to understand their right in monitoring the issuer operation activity which will ensure that the issuer credit ability to pay the coupon and principal still intact throughout the bond lifetime. Normally the issuer will agree on the most flexible covenant to allow some space for decision making and risk to improve its financial strength. The covenant will provide a safety mechanism for the bond holder and guideline for issuer to protect both its interest.

Nonetheless, it is paramount that private or institutional investors are well acquainted with any covenant clauses that subsist in the corporate bond agreement as if any stipulated clauses are breached by the issuer during the term, this circumstance will then trigger the introduction of a specific predefined event. It should be noted that bond covenants, even if restrictive or negative, can’t turn a bad investment into a good one. If the company is financially weak, bond covenants can’t improve the finances, so it is always better to avoid bonds that have high yields and a long list of covenants unless you are a bond expert. Bond covenants also don’t truly restrict bad management from making bad choices. They can help to position the bondholders to receive more favorable treatment in the event of company liquidation, but this is not a reason to buy a bond from a company that is likely to go into default.

 

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Disclaimer
This report has been prepared and issued by Bond and Sukuk Information Platform Sdn Bhd (“the Company”). The information provided in this report is of a general nature and has been prepared for information purposes only. It is not intended to constitute research or as advice for any investor. The information in this report is not and should not be construed or considered as an offer, recommendation or solicitation for investments. Investors are advised to make their own independent evaluation of the information contained in this report, consider their own individual investment objectives, financial situation and particular needs and should seek appropriate personalised financial advice from a qualified professional to suit individual circumstances and risk profile.
 
The information contained in this report is prepared from data believed to be correct and reliable at the time of issuance of this report. While every effort is made to ensure the information is up-to-date and correct, the Company does not make any guarantee, representation or warranty, express or implied, as to the adequacy, accuracy, completeness, reliability or fairness of any such information contained in this report and accordingly, neither the Company nor any of its affiliates nor its related persons shall not be liable in any manner whatsoever for any consequences (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) of any reliance thereon or usage thereof.