Quick Answer
Maintenance covenants are tested every fiscal quarter regardless of whether the borrower does anything; a breach of a maintenance test trips a default automatically. Incurrence covenants are tested only when the borrower attempts a specific action (incur debt, pay a dividend, sell an asset, grant a lien); a borrower can sit on a balance sheet that would fail an incurrence test indefinitely as long as it does not take the prohibited action.
Covenants are the contractual restrictions that protect creditors. Knowing when each style is tested and which document types they live in is the heart of the distress lending playbook.
Maintenance vs Incurrence: Side by Side
| Dimension | Maintenance Covenant | Incurrence Covenant |
|---|---|---|
| When tested | Periodically (typically each fiscal quarter) | Only when borrower takes a specific action (incur debt, pay dividend, sell asset, grant lien) |
| Trigger if breached | Default the moment the test fails, even if borrower does nothing | Default only if borrower attempts the prohibited action |
| Where found | Bank credit agreements (especially revolvers and pro-rata facilities) | High-yield indentures; covenant-lite syndicated term loans |
| Common examples | Maximum leverage ratio, minimum interest coverage, minimum fixed-charge coverage, minimum earnings before interest, taxes, depreciation, and amortization (EBITDA) | Restricted-payments basket, debt-incurrence test, lien-incurrence test, asset-sale covenant |
| Lender benefit | Early-warning trip wire; forces borrower to negotiating table while value remains | Backstop; prevents borrower from making the situation worse |
Exam Tip: Gotchas
- Maintenance covenants trigger default every quarter regardless of action. A borrower can wake up Monday morning in default just because September-quarter EBITDA was lower than expected.
- Incurrence covenants trigger default only at the moment of the prohibited action. A borrower can sit on a balance sheet that would fail an incurrence test forever; what it cannot do is incur more debt or pay a dividend until the test is satisfied.
- High-yield indentures are typically incurrence-only. The trustee will not declare default just because the leverage ratio drifted higher; this is the structural reason bond covenants are described as "looser" than bank-loan covenants.
Common Financial Covenant Ratios (Maintenance)
The maintenance covenants candidates should recognize on sight:
- Leverage ratio: Total Debt / EBITDA (capped at a ceiling, for example a maximum of 5.0x)
- Interest coverage ratio: EBITDA / Interest Expense (floored, for example a minimum of 2.5x)
- Fixed-charge coverage ratio: (EBITDA minus capital expenditures) / (Interest plus Scheduled Principal plus Lease Payments) (floored)
- Senior leverage / Net leverage: Senior Debt or Net Debt / EBITDA (capped)
- Minimum liquidity: Cash plus Revolver availability (floored at a dollar amount)
Each ratio is calculated on a defined adjusted-EBITDA number that excludes specified items (non-cash impairments, restructuring charges, certain pro forma cost savings). The definitions matter; one of the most common distressed-lending workouts is a renegotiation of EBITDA add-backs and the resulting headroom.
Exam Tip: Gotchas
- Leverage and senior leverage ratios are CAPPED (maxima). Borrower fails the test if leverage goes too high.
- Coverage and liquidity ratios are FLOORED (minima). Borrower fails the test if coverage drops too low.
- EBITDA definitions vary by document. Two different credit agreements may have very different headroom even if they appear to have the same nominal ratio because of the add-backs the definition allows.
Negative Covenants (Affirmative Restrictions)
Most credit agreements and indentures share the same families of negative covenants:
- Debt incurrence: restricts additional indebtedness, often with permitted-debt baskets for specified categories
- Lien incurrence: restricts additional secured debt and asset encumbrances, with a permitted-liens schedule
- Restricted payments: caps dividends, share repurchases, and certain investments through a builder-basket formula
- Asset sales: proceeds must be reinvested in the business or used to repay debt within a defined window
- Affiliate transactions: arm's-length pricing or board-approval requirements
- Change of control: typically a put right or mandatory prepayment trigger for the bondholder; sometimes a true event of default
Exam Tip: Gotchas
- Asset-sale covenants force reinvestment or debt repayment. A distressed borrower cannot simply take asset-sale proceeds and pay them out as a dividend; the proceeds are typically "trapped" by the asset-sale covenant.
- Change-of-control is often a PUT RIGHT, not an event of default. Bondholders get the right to require repayment at a premium (typically 101% of par) but the bonds are not automatically accelerated.
Short-Term vs Long-Term Liquidity Assessment
Bankers and credit analysts evaluate both windows when modeling distress:
- Short-term liquidity: cash on hand, revolver availability, working-capital cycle, and any debt maturities in the next 12 months
- Long-term liquidity: the maturity wall, mandatory amortization, required redemptions (for example, excess-cash-flow sweeps or sinking-fund payments), and refinancing risk
The maintenance-covenant headroom must be modeled on both horizons. A company can pass quarterly covenant tests for the next year and still face a refinancing crisis when a large maturity comes due 18 months out.
Exam Tip: Gotchas
- A maturity wall is a long-term distress trigger. Even if the borrower is current on payments, an approaching unrefinanceable maturity is itself a liquidity event that will likely require restructuring before the maturity date.
- Revolver availability can shrink even when committed. Borrowing-base limits, undrawn-revolver-fee step-ups, and "material adverse change" draw conditions can effectively close access to a revolver in distress.