I always mix up affirmative covenants and negative covenants in questions. They tell you that affirmative covenants force you to do stuff and negative covenants force you to not do stuff. But honestly, that’s not very useful. For instance, a covenant requiring that you keep a Debt/EBITDA below 4 is forcing you to DO something (keeping that ratio below 4) but it’s also requiring you to NOT DO something (letting that ratio go above 4).
The reading says that affirmative covenants are statements typically administrative in nature and it doesn’t cost much for a firm to add them to the bond indenture (since the firm is already required by law to obey such statements). Examples include making interest payments on time and paying taxes on time. Negative covenants, on the other hand, can be costly to a firm because it actually, in the real world, restricts its operations. I thought I finally understood the difference.
But here’s a practice question I just failed to answer on CFAI’s website:
Which of the following is most likely an example of a negative covenant?
- Dividend payout ratio not to exceed 25% [CORRECT]
- Maintain a debt-to-EBITDA ratio of 4.0 or less [My answer, WRONG]
- Company must redeem outstanding debt in event of takeover
My reasoning was that keeping a dividend payout ratio low is not costly to a firm because value is returned to shareholders in capital gains instead, but that keeping a debt/EBITDA ratio below 4 constrains operations and is costly.
A is correct. Negative covenants, also known as restrictive covenants, limit what a company can do. In this case, the company is limited to a dividend ratio of 25%. [Comment: OK, but alternatively the firm is obligated to maintain the dividend ratio below 25%, which spells out what the company is obligated to do.]
B is incorrect because affirmative covenants spell out what the company is obligated to do. In this case, the company is obligated to maintain a debt-to-EBITDA ratio of 4.0 or less. [Comment: OK, but alternatively the firm is limited in what it can do, specifically it cannot take on more debt when that would put its ratio above 4.]
Given that a “you must do” statement can often be rearranged to a “you must not do” statement with exactly the same meaning (and the other way around), how can you figure out whether something is an affirmative covenant or a negative one?
Thanks