Negative Covenant

Written By
Paul Tracy
Updated November 4, 2020

What is Negative Covenant?

A negative covenant is a promise a company makes to not exceed certain financial ratios or not conduct certain activities. Negative covenants are almost always found in loan or bond documents.

How Does Negative Covenant Work?

For example, let's assume Company XYZ wants to borrow $10 million from Bank ABC. The loan agreement contains negative covenants that limit Company XYZ to $0.10 per share in dividends per year and prevent it from issuing additional debt without Bank ABC's consent.

Negative covenants can exist in employment agreements and even merger or acquisition agreements, but they are most common in lending agreements and bond indentures. Covenants, in general, can be financial or operational in nature.

Operational covenants often require borrowers to maintain their physical assets to a certain standards, meet minimum disclosure requirements, engage only in permissible business lines, or maintain a certain level of insurance.

Financial covenants are frequently ratios that the borrower is required to stay above or below (a 2:1 debt-to-equity ratio or interest coverage ratio, for example), but there are usually also restrictions on debt levels and minimum working capital requirements.

The lending agreement or indenture in which the negative covenant appears will also provide detailed formulas to be used to calculate the ratios and limits on negative covenants. It is important to note that in many cases these formulas do not conform to generally accepted accounting principals (GAAP). For example, the negative covenant may include leases in a debt-limit calculation, or it may consider capital leases as an expense. As a result, it is very important that borrowers scrutinize covenants before borrowing.

Why Does Negative Covenant Matter?

Lenders attach negative covenants to bond issues and loans as a way to force the borrower to operate in a financially prudent manner that most ensures it will repay the debt. Issuers, on the other hand, usually negotiate the most flexible covenants they can so they have the freedom to make decisions and take risks that might ultimately benefit the lenders and the shareholders. Thus, the more negative covenants a bond issue has, the lower the interest rate on those bonds tends to be.

Violating a negative covenant can trigger a technical default. This means that although the issuer is making interest and principal payments on time, it is not operating within the agreed-upon guidelines and is thus increasing the risk of nonpayment in the eyes of the Lenders or bondholders. Often borrowers have a certain amount of time to remedy (or "cure") the technical default (for example, the borrower must lower its debt-to-equity ratio within thirty days), but technical defaults often lower the borrower's credit rating and stock price.

Activate your free account to unlock our most valuable savings and money-making tips
  • 100% FREE
  • Exclusive money-making tips before we post them to the live site
  • Weekly insights and analysis from our financial experts
  • Free Report - 25 Ways to Save Hundreds on Your Monthly Expenses
  • Free Report - Eliminate Credit Card Debt with these 10 Simple Tricks
Ask an Expert
All of our content is verified for accuracy by Paul Tracy and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Negative Covenant.
Be the first to ask a question

If you have a question about Negative Covenant, then please ask Paul.

Ask a question

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

If you have a question about Negative Covenant, then please ask Paul.

Ask a question Read more from Paul
Paul Tracy - profile
Ask an Expert about Negative Covenant

By submitting this form you agree with our Privacy Policy

Don't Know a Financial Term?
Search our library of 4,000+ terms