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CFA Level I · CFA Level I Exam · Credit Risk

A bond indenture requires the issuer to maintain a minimum interest coverage ratio and limits additional borrowing. Compared with an otherwise identical bond without these provisions, the covenants are most likely to:

The covenants most likely protect bondholders by providing early warning of deteriorating credit quality. A breach of a coverage ratio or debt limit lets creditors act before default. They do not replace capacity analysis, and they generally reduce rather than raise credit risk for lenders.

  1. Araise the issuer's default risk by restricting financial flexibility
  2. Bprotect bondholders by giving early warning of deteriorating credit qualityCorrect
  3. Cremove the need to analyze the issuer's capacity to repay

Explanation

Affirmative and negative covenants protect creditors by limiting actions that harm them and by triggering a breach before the issuer becomes insolvent, which gives bondholders an early opportunity to act. They do not eliminate the need to assess capacity. Restricting borrowing generally lowers rather than raises credit risk for bondholders.

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