Incurrence Covenant

An incurrence covenant is a contractual restriction in a bond agreement that the issuer must comply with only when it takes a designated action—typically borrowing additional money, paying dividends, or making major asset sales. Unlike maintenance covenants, which must be met on every reporting date regardless of company behavior, incurrence covenants act as gatekeepers: they determine whether a specific transaction is even permitted.

How incurrence covenants work

The structure is straightforward: the issuer remains free to operate and make financial decisions until it attempts one of the restricted actions. At that moment, it must demonstrate compliance with a specified financial test. If the company wants to issue new debt, for instance, its leverage ratio might need to stay below 4.0x. If it wants to pay a large dividend, interest coverage might need to exceed 2.5x. Only if the test passes does the transaction proceed.

This creates a permission system baked into the bond agreement. The issuer does not have unlimited optionality; it cannot simply expand its debt load or distribute cash to shareholders at will. But it retains flexibility in the vast majority of normal operations—payroll, operations, organic reinvestment, modest asset swaps.

The covenant language typically reads: “The Issuer shall not incur additional Indebtedness unless, in the case of Indebtedness of the Company, the Total Leverage Ratio as of the date of incurrence shall not exceed 4.50x.” This means the issuer may issue as much debt as it likes, up to the point the leverage test fails.

Why lenders use incurrence tests

Incurrence covenants address a key lender concern: moral hazard. Once a company has borrowed, its incentive to take on risk can increase—a phenomenon called “asset substitution.” With an incurrence covenant in place, the company cannot gradually lever itself into distress; it hits a wall. Want to go from 3.0x leverage to 5.0x? Not without bondholder consent.

From a practical standpoint, incurrence covenants also reduce the frequency of covenant negotiations. A maintenance covenant breach triggers a technical default and often forces the company to renegotiate or amend the bond terms. An incurrence covenant breach simply blocks the contemplated transaction. If the company gives up on the acquisition or new debt issuance, nothing changes for existing bondholders.

For high-yield borrowers—companies with weaker credit ratings—incurrence tests are often the primary credit protection. A struggling company can still operate and try to turn around; the covenant only restricts expansion or cash distributions when balance-sheet metrics deteriorate.

Common incurrence tests

Leverage ratios are the most prevalent test. A typical threshold might be Total Debt divided by trailing twelve-month EBITDA (see EBITDA), capped at 4.5x or 5.0x. When the issuer attempts new borrowing, it calculates the pro-forma leverage ratio including the new debt, and if it would exceed the cap, the deal is blocked.

Interest coverage is another common metric, requiring that EBITDA exceed interest expense by a minimum multiple—often 2.5x or 3.0x—before the issuer can incur debt.

Fixed charge coverage combines operating cash flow, interest payments, and sometimes lease or capital-expenditure obligations into a single ratio test.

Some bonds restrict dividend payments by incurrence covenant. An issuer might be allowed to pay a dividend only if leverage remains below 3.0x. This aligns the interests of equity and debt holders: if the balance sheet weakens, equity gets paid last.

Asset sale restrictions also appear in incurrence language. An issuer might be prohibited from selling assets above a certain threshold unless proceeds are used to repay debt or reinvested in the business within a specified period.

Incurrence vs. maintenance: a critical distinction

The difference is timing and consequence. A maintenance covenant is tested every quarter (or every half-year). If the company fails the test on any measurement date—say, leverage creeps to 4.6x when the max is 4.5x—the bondholders are immediately entitled to declare a default and accelerate repayment. The company now faces a refinancing crisis.

An incurrence covenant is tested only when the forbidden action is attempted. If leverage is 4.6x but the company does not issue new debt or pay dividends, no covenant is breached. The high leverage itself is not the violation; the attempted transaction triggers the test.

This distinction has profound consequences for how companies manage their finances. A company with only incurrence covenants can operate at high leverage indefinitely, provided it does not try to grow debt further. A company with tight maintenance covenants cannot: it must continuously manage metrics to stay compliant on every reporting date, even if it takes no major action.

Modern bond indentures typically include both types of covenants. Maintenance covenants cover the baseline financial health test; incurrence covenants gate aggressive expansion.

Real-world application and negotiation

In practice, incurrence covenants are negotiated based on industry, company credit quality, and deal structure. A private equity firm financing a leveraged buyout will argue for higher leverage thresholds and fewer restricted actions—more flexibility to operate and strip cash. Lenders push for lower thresholds and broader restrictions (equity purchases, share buybacks, and asset sales all counted as cash distributions).

The definition of “incurrence” itself is a battleground. Does it include acquired debt, or only new debt issued by the company? Does it count operating leases? Are contingent liabilities included? Bond indentures spell these out in exhaustive detail.

A company in financial distress will sometimes seek to amend or “waive” the incurrence covenant to allow a strategic transaction. This typically requires bondholder approval—either unanimous consent or a supermajority vote—and may come with a price (higher yields, amended terms, or direct payments to bondholders).

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