Hopefully this post will make that task easier by providing context through a real-life example and its publicly filed bond indenture documents. But first, let\u2019s start by talking about covenants.<\/p>\n\n\n\n\n\n\n\n
Why are Bond Covenants there in the first place?<\/h2>\n\n\n\n
Covenants can be an important part of a bond indenture especially if the issuer has more of a default risk, because as you might learn in Corporate Finance 101, the financial incentives of bondholders and equity holders don\u2019t always align.<\/p>\n\n\n\n
For example, equity holders might like to see a company lever up a very conservative balance sheet in order to spurn additional growth opportunities in the future for free cash flows and earnings.<\/p>\n\n\n\n
But since bondholders are generally paid only on fixed principal and interest payments and receive no benefit from the growth of a business (other than potentially reduced default risk), an aggressive levering of a business might benefit equity holders (or owners) of a business while potentially endangering bond holders to greater risk.<\/p>\n\n\n\n
To protect against this potential of a conflict of interest, bondholders might demand covenants to reduce the ability of the company to lever in the future, either by requiring the company to adhere to minimum levels of solvency as measured by certain metrics, or requiring prepayment before accruing additional debt.<\/p>\n\n\n\n
Keep in mind that bond issuances and pricings are a negotiation just like the buying and selling of bonds or stocks is.<\/p>\n\n\n\n
A more credit-worthy issuer might get away with a bond indenture with no debt covenants because of its strong financials and track record, or an issuer might pay a higher yield in lieu of more restrictive debt covenants, or vice versa, just as an example.<\/p>\n\n\n\n
How to Find a Bond Indenture from a 10-k<\/h2>\n\n\n\n
Now let\u2019s get to the meat and potatoes through a real-life example of a bond indenture. I\u2019m going to take a publicly traded company called Casey\u2019s General Stores ($CASY), a company who disclosed their bond covenants as a risk factor in their 10-k.<\/p>\n\n\n\n
I\u2019ll use the company\u2019s latest 10-k from a great website called bamsec.com<\/a>.<\/p>\n\n\n\n Usually you\u2019ll find bond indentures and other related documents in the \u201cExhibits\u201d of a 10-k, which are usually found at the bottom of the document. If you\u2019re having trouble locating a particular bond indenture, you might want to look at the Debt section of a company\u2019s Notes to the Financial Statements<\/a> and see which exhibit the company references to explain their debt terms (it might direct you to an 8-k<\/a>, for example).<\/p>\n\n\n\n For Casey\u2019s, we can see various \u201cNote Purchase Agreements\u201d; since bonds are often referred to as Senior Notes we can think to start here.<\/p>\n\n\n\n I\u2019m going to click on the latest one first, dated June 30, 2020 and filed July 7, 2020.<\/p>\n\n\n\n Right at the top, we see the following terms:<\/p>\n\n\n\n If you scroll through the table of contents, you\u2019ll see sections such as 8. MATURITY OF THE NOTES; PREPAYMENT, which will tell you whether the $325,000,000 principal and interest is due in installments or all at once at the due date (known as a balloon payment).<\/p>\n\n\n\n What I\u2019m interested in, and any stock market investor should be, is any restrictive debt covenants. In this case, we can see the following sections which look interesting:<\/p>\n\n\n\n You could certainly read every section and use an extensive knowledge of legalese to do so; I\u2019m not a lawyer and so I have to make best estimates instead (as I think most investors should do with all parts of fundamental analysis).<\/p>\n\n\n\n Here\u2019s what this indenture document describes under Excess Leverage Fee (with all highlights mine):<\/p>\n\n\n\n Here we can see pretty clearly that there\u2019s a sort of maximum Leverage Ratio that would behoof the company to stay under. I highlighted at the bottom how it does not indicate default, but it does limit some of the other conditions, which could be further investigated in Section 3.<\/p>\n\n\n\n In this case, we need to understand that \u201cLeverage Ratio\u201d can be defined differently depending on who you\u2019re talking to, so we need to find how Leverage Ratio is defined in this bond indenture.<\/p>\n\n\n\n We could certainly search (\u201cctrl+f\u201d) the document to find where Leverage Ratio is defined; I\u2019m skipping to section 10 because I know we\u2019ll see the definition there.<\/p>\n\n\n\n Here\u2019s section 10.1 Financial Covenants, also clear for the most part (highlights mine). Section 10.2 Priority Debt is a small section, so I included it as well.<\/p>\n\n\n\n Admittedly this section is a little bit more intense, but if we read it closely we should be able to intelligently follow along.<\/p>\n\n\n\n 1\u2014<\/strong> First we get the definition that Leverage Ratio is defined as Consolidated Total Debt \/ Consolidated EBITDA of the last 4 quarters. Like stated in 9.10, this should not increase above 3.5.<\/p>\n\n\n\n But, we see an exception where if the company makes a \u201cMaterial Acquisition\u201d, it is allowed to be increased to 4x for 4 quarters with enough written notice to the bondholders. This is where we see why 9.10 is there, where the company could go above a Leverage Ratio of 3.5 temporarily after an acquisition but would have to pay the Excess Leverage Fee.<\/p>\n\n\n\n 2\u2014<\/strong> The Fixed Charge Coverage is the second covenant to be aware of for this company. We can see the formula is defined as (all values are \u201cconsolidated):<\/p>\n\n\n\n = EBITR \/ (Interest + Rent Expense)<\/strong><\/p>\n\n\n\n Personally, I\u2019m not really familiar with \u201cEBITR\u201d so let\u2019s dig further. By inputting \u201cEBITR\u201d into a search function, we find it additionally mentioned here (in Schedule B; DEFINED TERMS):<\/p>\n\n\n\n Basically we have Net Income + Taxes + Interest Expense + Rental Expense.<\/p>\n\n\n\n So the EBITR translates to Earnings Before Interest and Taxes and Rental Expense. Makes sense after finding the definition but always good to double check if you\u2019re unsure.<\/p>\n\n\n\n This Fixed Charge Coverage Ratio should not be below 2x. Simple too.<\/p>\n\n\n\n 3\u2014<\/strong> Consolidated Net Worth is also defined in Schedule B; it\u2019s simply consolidated Shareholder\u2019s Equity which is what I would\u2019ve guessed.<\/p>\n\n\n\n We have a very specific number that Shareholder\u2019s Equity must stay above, presumably to attain a desired Debt to Equity type ratio you\u2019ll tend to see in balance sheet analysis<\/a>.<\/p>\n\n\n\n But, this covenant also allows for 25% of Net Income to be added to Shareholder\u2019s Equity in case that equity dips below $462,679,000.<\/p>\n\n\n\n I would say that the answer to this question should be a yes, but with a stipulation. I think doing this could be very tiring for an investor and all such time consuming efforts should be weighed against finding new and better opportunities or doing different kinds of detailed research on the same company.<\/p>\n\n\n\n Here\u2019s how I approach which some of you might find useful.<\/p>\n\n\n\n You\u2019ll want to go back to the company\u2019s Notes to the Financials in order to see exactly how many senior notes or other bonds the company has issued up to now.<\/p>\n\n\n\n Here\u2019s what that looks like for Casey\u2019s:<\/p>\n\n\n\n![\"\"](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2021\/07\/bonds1.png?strip=all&lossy=1&ssl=1\")
<\/a><\/figure><\/div>\n\n\n\n![\"\"](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2021\/07\/bonds2.png?strip=all&lossy=1&ssl=1\")
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<\/a><\/figure>\n\n\n\n![\"\"](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2021\/07\/bonds4-1024x707.png?strip=all&lossy=1&ssl=1\")
<\/a><\/figure>\n\n\n\n![\"\"](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2021\/07\/bonds5-1024x198.png?strip=all&lossy=1&ssl=1\")
<\/a><\/figure><\/div>\n\n\n\nShould I read all of a company\u2019s Bond Indentures?<\/h2>\n\n\n\n
![\"\"](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2021\/07\/bonds6.png?strip=all&lossy=1&ssl=1\")
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