The dictionary meaning of a covenant is “an agreement between members to do a specific thing. For example, a peace treaty among multiple countries is a type of covenant.”
In the context of covered bonds, A covenant is simply an agreement between the issuer and the debenture trustee to follow some pre-decided conditions.
When you lend money to someone or to a company, there is some inherent risk that you carry. For example, suppose you lend money to a company because you believe in the potential of their senior management team, but what if the promoters only leave the company once you have lent money to the company. Now, after this, the company might not perform equally well. Similarly, there can be many such scenarios where a promising looking company might not perform equally well at all points of time in the future.
To mitigate this risk of uncertainties, a lender can sign an agreement with the borrower company to follow some pre-determined conditions. In our above example, an agreement that the promoters have to stay in the company until the borrowed money is repaid. This agreement is called a Covenant.
There are different types of Covenants based on the nature of the agreement. The above example was an example of Affirmative covenants. Similarly, there are various other covenants like negative covenants, financial covenants, reporting covenants etc.
A negative covenant is an agreement where the lender restricts the company to undertake certain actions. For example, The Borrower company cannot acquire any other company without the consent from the debenture trustee/holders.
A financial covenant tries to map the financial performance of the company and calls a trigger event in case the performance is below accepted levels. For example, if the GNPA of the company rises above “x%” then the company will have to repay all the money immediately.
A reporting covenant requires a company to report any significant event within a specified time period. For example, the company should report any change in the shareholding structure of more than 3%.