Understanding Protective Covenants

D

Protective covenants are contractual provisions included in bond indentures, loan agreements, and other debt securities. These provisions are designed to protect the interests of bondholders by limiting the actions of the issuer and ensuring that certain conditions are met throughout the life of the bond.

Option D, "To protect bondholders," is the correct answer.

Protective covenants may include various restrictions and requirements, such as limits on additional borrowing, restrictions on asset sales, and minimum financial ratios. These provisions are put in place to protect the bondholders' investment and to reduce the risk of default or other adverse events that could negatively impact the value of the bond.

For example, a bond indenture may include a debt service coverage ratio covenant, which requires the issuer to maintain a certain level of cash flow to ensure that it can meet its debt payments. Alternatively, an issuer may be restricted from issuing additional debt without the permission of the bondholders, ensuring that the issuer does not overburden itself with debt and increase the risk of default.

In summary, protective covenants are provisions included in debt securities to protect the interests of bondholders by limiting the actions of the issuer and ensuring that certain conditions are met. The purpose of these covenants is to reduce the risk of default and protect the value of the bond.