Maintenance vs Incurrence Covenants, Explained
The question
Explain the difference between maintenance and incurrence covenants, give one concrete example of each, and state which instrument each is typically found in.
General educational practice only. This is not an actual, confidential, leaked, or firm-provided interview question. Check important technical details against primary learning materials.
The answer
Maintenance covenants are tested every quarter regardless of whether the company takes any action, while incurrence covenants are tested only when the company chooses to do something like raise new debt or pay a dividend.
A concrete maintenance example would be total net leverage shall not exceed six times; if leverage drifts above that threshold, it is a technical default even if the company made every interest payment on time. An incurrence example would be the company may not incur additional debt unless pro forma fixed charge coverage is at least two times; that test only bites when the company actually tries to borrow more.
Maintenance covenants are traditionally found in bank loans, though most large broadly syndicated term loan Bs are cov-lite and remove that quarterly test. Incurrence covenants are standard in high-yield bond indentures, where investors rely on them to constrain the issuer from taking actions that would impair credit quality.
Yield curve: normal vs. inverted
Also asked as
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- Where exactly is the dividing line between investment grade and high yield on the S&P and Moody's scales, and why does crossing it matter economically for an issuer?
- Contrast a leveraged term loan B and a senior unsecured high-yield bond across five dimensions: rate structure, security/seniority, call protection, amortization, and primary investor base.
- High-yield spreads move from 350 bps to 550 bps over three months while Treasuries are flat. Walk through what happens to (a) outstanding HY bond prices, (b) a sponsor's maximum supportable leverage on a new LBO, and (c) banks holding committed but unsyndicated financing.
- A borrower's credit agreement has a springing net-leverage covenant of 7.0x, tested only when revolver draws exceed 35% of commitments. Explain what 'springing' and 'cov-lite' mean here, and why lenders agreed to this structure.
- Why does a callable high-yield bond trading above its call price exhibit 'negative convexity,' and why must investors quote yield-to-worst rather than yield-to-maturity on it?
- A company has $1,600M debt, $100M cash, and $300M covenant EBITDA with a 6.5x maximum net leverage maintenance test. Compute current leverage and the percentage EBITDA decline that triggers a breach. Then: management wants to draw $200M on the revolver to fund an acquisition adding $25M of EBITDA. Does the pro forma pass?
- Same issuer, three instruments: first-lien TLB at SOFR+375 (SOFR = 4.25%), senior unsecured notes at 8.9%, and a proposed second-lien tranche. First-lien debt is 4.0x EBITDA, the enterprise is worth 7.0x in a downside scenario, and the second lien would add 1.5x. Where should the second lien price relative to the notes, and why? Use attachment points in your reasoning.
- You hold $400M face of 8.5% notes, callable today at 104.25, next year at 102.125, at par in two years; they mature in four years and trade at 104.75. New four-year paper for this issuer would price at 6.75%. Compute yield-to-worst intuition (which call dominates), the payback period of calling today, and the coupon on new debt a year from now above which calling today was the right move.
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