Covenants
Clauses in a bond's indenture specifying the rights of bondholders and restrictions on the issuer. Positive covenants say what the issuer must do; negative covenants say what it must not do.
In plain language
Lending money to a company for seven years is an act of trust. Covenants are how bondholders put some of that trust in writing.
The workbook defines covenants as clauses specifying the rights of the bond holders and restrictions on the bond issuers. They live inside the bond's indenture, the legal agreement between issuer and bondholders.
There are two kinds, and the names are easy to remember:
- Positive covenants are actions which issuers are required to do.
- Negative covenants specify what issuers are prohibited from doing.
Together they are, in the workbook's words, necessary to protect an investor's investment in the debt security.
How it works
Where covenants sit (Chapter 4, section 4.3). A bond's safety depends on the probability of default — the chance the issuer fails to pay coupon and principal in full and on time — and on the possibility of delay. That is credit risk. The indenture is the most important document for understanding safety, and covenants are one of the things it provides information on, alongside par value, coupon, maturity, collateral, seniority and options.
The two types.
| Type | Workbook definition | What it does for the bondholder |
|---|---|---|
| Positive covenant | Actions issuers are required to do | Obliges conduct that supports repayment |
| Negative covenant | What issuers are prohibited from doing | Blocks conduct that would weaken the bondholder's position |
How they relate to the rest of bond safety.
- Secured bonds: quality depends on the value of the asset the bond is secured against.
- Unsecured bonds: backed by the issuer's promise, so the creditworthiness of the issuer determines quality.
- Credit rating agencies assess the ability and willingness of issuers to meet obligations on time, rating each instrument from AAA (highest safety) to D (in default or expected to be).
Covenants do not remove credit risk. They shape the issuer's behaviour so that the promised payments are more likely to be made.
A worked example
The workbook defines the two types but gives no specific covenant wording. The clauses below are illustrative examples of each type, not quotations.
A manufacturing company raises ₹500 crore through unsecured bonds. The indenture includes:
| Clause (illustrative) | Positive or negative? | How it protects bondholders |
|---|---|---|
| Company must keep its plant and machinery insured | Positive — required action | Protects the assets that generate cash to repay |
| Company must provide audited financial statements to the trustee every year | Positive | Lets bondholders monitor health |
| Company shall not sell its main factory without bondholder approval | Negative — prohibited action | Stops cash-generating assets leaving the business |
| Company shall not pay dividends if interest cover falls below an agreed level | Negative | Keeps cash for creditors when times are hard |
Imagine the company later wants to pay a large special dividend of ₹150 crore while its earnings are weak. Without the negative covenant, cash that could service the bonds would go to shareholders. With it, the dividend is blocked until the company's position improves.
A distributor explaining a fixed income PMS portfolio can use this to show why two bonds with the same rating and coupon may still differ in how well they protect the investor.
Why NISM asks about it
Covenants are covered in Chapter 4 (Investing in Fixed Income Securities), section 4.3, "Determinants of bond safety", immediately after the indenture. It is a classic definition item: which kind of covenant requires an action and which prohibits one. The same section connects covenants to secured versus unsecured bonds, credit risk and the SEBI-standardised credit rating symbols in Boxes 4.1 and 4.2.
Common exam traps
- Positive = must do; negative = must not do. "Negative" does not mean harmful to the investor — negative covenants protect investors.
- Covenants are clauses in the indenture, not a separate contract.
- Covenants restrict the issuer and set out bondholders' rights — not the rating agency's or the exchange's.
- They reduce, not eliminate, credit risk.
- Unsecured bonds rely on issuer creditworthiness; covenants are one of the protections available.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- Credit ratingAn opinion on how likely a borrower is to service an instrument on time, reduced to a symbol by a SEBI-registered rating agency — and reviewed continuously, not fixed for the life of the bond.
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Debenture trusteeThe SEBI-registered trustee of the trust deed securing an issue of debentures — the debenture holders' agent, standing between them and the issuer for the life of the paper.
- Fixed income securityA debt instrument under which the issuer promises a fixed coupon at regular intervals and repayment of the face value at maturity — government bonds, corporate bonds, debentures and T-bills.
- IndentureThe legal agreement between a bond issuer and its bondholders setting out every term of the debt — par value, coupon, maturity, collateral, seniority, options and covenants.