Why is it important for debt investors to add covenants?

Adding covenants to a debt agreement is crucial for protecting the interests of debt investors. Covenants are stipulations or conditions that the borrower must adhere to throughout the term of the loan. Their primary purpose is to monitor the borrower's financial health and operational practices, which helps mitigate the risk of default.

By implementing covenants, investors can proactively manage risks associated with lending money. These safeguards can take various forms, such as maintaining specific financial ratios (like debt-to-equity or interest coverage ratios), restricting additional debt, or requiring regular financial reporting. Such measures enable investors to gain insights into the borrower’s ongoing performance and financial stability.

When covenants are in place, they provide early warning signs if a company's financial condition begins to deteriorate, allowing investors to take action before a default occurs. This proactive monitoring and measurement of performance help ensure that the issuer remains capable of meeting its debt obligations, thus reducing the likelihood of unforeseen defaults that could jeopardize the investors' returns.