Why Buying A Bond Is Like Marrying Tiger Woods

Written By
Paul Tracy
Updated January 16, 2021

Celebrities divorce at twice the rate of us mere mortals, according to a report by The Marriage Foundation.

That's probably to be expected when so many of them tie the knot after knowing each other for approximately 10 minutes; but often, celebrity divorces are also the result of brazen affairs with housekeepers, directors, co-stars or, in some cases it seems, anybody who walks down the street.

These broken promises -- to love and honor -- can be very expensive for luminaries: Mel Gibson reportedly forked over $425 million to Robyn Gibson after she found out he had a girlfriend and a love child, Arnold Schwarzenegger allegedly paid Maria Shriver at least $250 million after she found out he had a son with the maid, and Elin Nordegren went back to Sweden with a reported $750 million after her divorce from golfing icon Tiger Woods.

The moral of the story is that breaking promises gets expensive, and that rule applies in the business world, too -- especially when companies borrow money.

Here are some terms you need to know to understand those promises and what happens when they're broken.

Indenture Agreement

An indenture agreement is a formal contract between a bond issuer (the borrower) and bondholders (the lenders). It's like a prenuptial agreement: It sets forth the details of all the terms and conditions of the bonds, such as the exact day of their maturity, the timing of the interest payments and how they are calculated, as well as the details of any special features. It also sets forth rules about how the issuer can and can't manage its money.

These rules are called covenants.

Covenants

A covenant is a solemn promise. There are two primary types of covenants.

Operational covenants often require borrowers to maintain their physical assets to 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. Financial covenants usually limit the borrower’s purchase of new assets, changes in control, the use of the borrowed funds, and the payment of dividends (so that shareholders cannot vote to pay themselves huge dividends, leaving nothing for the creditors). Some may also limit officer compensation packages.

The indenture agreement provides detailed formulas for calculating the ratios and limits on covenants.

Why do lenders attach covenants to bond issues and loans? To make sure the borrower operates in a financially prudent manner that most ensures it will repay the debt. In other words, the lender wants to make sure the company isn't going to blow its cash and stiff everyone.

You can understand, then, why lenders like to put as many tight covenants on a borrower as they can. That's why borrowers usually negotiate the most flexible covenants they can. Their argument is that they want the freedom to make decisions and take risks that might ultimately benefit the lenders and the shareholders.

Default

Violating a covenant can trigger a technical default. This means that even though the borrower is making payments on time, it's not operating within the agreed-upon guidelines and is thus increasing the risk of nonpayment in the eyes of the lender or bondholders.

Technical default is a very bad thing. 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 30 days), but technical defaults often lower the borrower’s credit rating and stock price.

If the borrower doesn't cure by the deadline, the lenders usually have the right to call the loan -- that is, make the borrower repay all of the debt immediately. This is also a very bad thing. If the borrower can't make that big payment (which is not unusual), then the lender gets to seize the collateral or even the borrower's inventory or bank accounts.

Ratings agencies such as Moody's and Standard & Poor's research and analyze companies in an effort to measure their default risk on a particular security. The result of their work is credit ratings that investors can track and compare with other issuers.

The Investing Answer: Promises can be hard to keep, especially when that cute blonde is winking at you, but that doesn't mean promises don't have to be kept.

The next time you buy a bond, get a copy of the indenture agreement and read it. You'll see just how much room a company has to flirt.

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