What is the purpose of protective covenants in financial agreements?

The purpose of protective covenants in financial agreements primarily revolves around safeguarding the interests of bondholders or creditors. These covenants are stipulations or clauses incorporated into loan agreements, bond indentures, or other financial contracts that impose certain limitations or requirements on the borrower.

By restricting certain actions or requiring the borrower to maintain specific financial ratios, protective covenants help ensure that the company remains financially stable and does not take on excessive risk that could jeopardize the ability to repay the debt. For instance, covenants may limit the amount of additional borrowing, dictate how proceeds from asset sales can be used, or require the maintenance of certain liquidity ratios. This structure provides reassurance to bondholders that their investment is protected, thus reducing the risk of default.

While covenants may provide some level of transparency or compliance with regulations, their primary focus is to create a framework that prioritizes the security and repayment capabilities for those who have lent money to the firm. This makes them vital instruments in credit agreements, where maintaining the confidence of bondholders is crucial for the ongoing financial health of the company.