Debt Markets in Canada

In the previous unit we saw how investments could broadly be classified as debt, equity or derivatives. In this
unit we delve into the first of the three investment types, debt. The primary debt markets in Canada for
investors are the money market and the bond market. The difference between them is the length of time that
money is invested. The money market is for funds being invested for less than a year, whereas the bond market
is for investments greater than a year. In terms of size, the bond market passed the $2 trillion mark in 2014,
whereas the money market was about one-sixth of that.
The Money Market
The money market is comprised of very short term debt securities. The objective of money market investors
is to generate safe, short term returns. Investors are investing their surplus cash on a short term basis in order to
maintain liquidity for their operations. Every type of business from manufacturers to financial institutions to
high tech companies, as well as governments participate in this market. Investments can be overnight or for up
to a year. The risk levels vary by instrument but are generally fairly small, given the debt must be repaid within
the year.

The 5 main investment alternatives in the Canadian money market are treasury bills, certificates of deposit,
bankers acceptances, commercial paper, and repurchase agreements.
Treasury Bills
Treasury bills (t-bills) are short term debt securities issued by the government. In Canada they are usually
issued at a bi-weekly auction for maturities of 1 month, 2 months, 3 months, 6 months and 1 year. They can
subsequently trade in a secondary market though most investors hold them to maturity. As they are backed by
the government, the credit risk is considered to be as close to nil as possible.

T-bills are quoted based on a face value of $1,000, meaning they are worth $1,000 at maturity. T-bills do not
pay interest on the face value but rather, they are sold at a discount. This means the investor buys them for a
price less than $1,000 and receives $1,000 at maturity. The price of a t-bill at any time is therefore the present
value of $1,000, given the maturity date. This is a direct example of the present value of a single payment we
studied in Unit 1.

Example Box
a) What is the price of a 6 month $1,000 treasury bill that was issued at a 2% semi-annual yield?
b) How much would the investor receive at maturity?
Solution
a) The treasury bill would be sold to the investor at a price of:
PV = 1000*(1 + .02/2)-1 = $990.10
b) At the end of 6 months, the investor would receive $1,000, thus earning 2% semi-annual on their
investment.

Certificates of Deposit
Certificates of deposit are deposits with a bank for a specific term. They are similar to a retail GIC
(Guaranteed Investment Certificate). The term can be virtually any length of time the investor chooses from
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overnight to a year, and can include a non-standard number of days (i.e. does not have to be a set number of
weeks or months). The risk is that of the bank holding the deposit. In Canada, all of the largest banks have their
short-term deposits rated in the safest category.
Unlike the t-bill, the interest on a certificate of deposit is paid at the end of the term on the face value.

Example:
a) What is the price of a 6 month certificate of deposit for $1,000 at a 2% semi-annual yield?
b) How much would the investor receive at maturity?

Solution
a) The investor would pay $1,000 for the deposit.
b) At the end of the 6 months the investor would receive:
FV = 1000*(1+.02/2) = $1,010.00.

Bankers’ Acceptances
Bankers’ Acceptances (BAs) are post-dated cheques issued by a corporation and then physically stamped by
a bank. The stamp guarantees the cheque will be honoured by the bank. Historically BAs were used for
international trade to guarantee foreign suppliers that they would be paid. Today, they are also used as pure
financial transactions to raise money - the corporation can choose any term up to a year. Normally the term is
less than 90 days. The credit risk is the same as the bank’s which as mentioned above, means that in the case of
the big Canadian banks, the risk is quite small.

BAs can be traded between investors - when they are sold, they sell at a discount to the face value on the draft,
based on the credit rating of the bank and the time to maturity (similar to a t-bill). The bank charges the issuing
corporation a stamping fee - the size of the fee depends on the corporation’s credit rating. The holder of the BA
can present it to the stamping bank for payment on the maturity date.

Commercial Paper
Commercial paper (CP) is short term unsecured debt issued by a corporation; the term is less than one year
and they are normally issued in multiples of $50,000. The CP is rated by a rating agency (Standard & Poor’s,
Moody’s, Fitch, Dominion Bond Rating Service) which lets investors know the agency’s opinion on the safety
of the CP. Many investors set their investment policies based on these ratings (e.g. will only invest in paper
rated in the safest or second safest rating).

Similar to t-bills, CP is sold at a discount, paying the face amount on the maturity date. They can trade between
investors but typically investors hold them to maturity.

Repurchase Agreements
Repurchase Agreements (repos) are standardized agreements whereby an investor (or lender) buys a security
from an investee (or borrower). The investee agrees to buy it back at a higher price on a specified future date
(normally within 2 weeks). The most common term is overnight. This gives the investor a debt-like return. The
rationale for this type of arrangement was to get the security off the investee’s balance sheet.

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Repos are almost always done using government securities. For example, an investee sells $100,000 of 3 month
Canadian t-bills to an investor, agreeing to buy them back in 1 week for say, $100,019.23 (the rate in this case is
1% compounded weekly). Repos are considered to be very secure since if the investee defaults, the investor can
sell the underlying government security (in this case, the 3 month t-bills). The investees (or borrowers) are
typically the banks and broker/dealers; the investors (or lenders) are money market funds and large financial
institutions

Risk and Return of Money Market Alternatives

In terms of ranking the risk and hence the size of the returns offered by each alternative, t-bills are the least
risky and offer the lowest return, followed by repos (since the underlying security is a government security),
followed by certificates of deposit and BAs (both represent bank credit risk) and lastly, CP (corporate risk
which in Canada is almost always inferior to the big banks). Hence 1-month CP will typically carry higher
returns than 1-month returns in any of the other alternatives. The Bank of Canada publishes an updated list of
current rates at the following website: http://www.bankofcanada.ca/rates/interest-rates/money-market-yields/

Other rates that are utilized as benchmarks in the money market are:
 Canadian Overnight Rate: the rate at which Canadian banks borrow from each other on an overnight,
unsecured basis; the target is set and published by the Bank of Canada
 U.S. fed funds rate: the rate at which U.S. banks borrow from each other on an overnight, unsecured
basis
 U.S. fed discount rate: the rate charged by the U.S. federal reserve bank when it lends to banks, again,
on an overnight, unsecured basis
 LIBOR – the London InterBank Offering Rate: the rate banks in London (U.K.) charge each other for
unsecured borrowings. It is currently quoted for 5 currencies (US, EURO, GBP, JPY and Swiss Franc)
and 7 borrowing periods (overnight to a year). It is an important rate since it is used on a huge number of
debt and derivative agreements around the world as the base rate for their interest calculation (e.g.
interest to be calculated as LIBOR + 1%). Presently, the total dollar value of contracts using LIBOR is
estimated at US$260 trillion.

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The Bond Market
A bond is a form of debt in which the borrower (or issuer) issues a debt security to an investor. Unlike other
forms of borrowing, bonds can trade publicly and are regulated by securities commissions. The most common
structure is a security that pays a fixed amount of interest every six months, i.e. a semi-annual interest rate, with
the full amount of principal being repaid at maturity. The debt can be either secured or unsecured and can have
many other features as well. Every bond issue has a bond indenture that states in legal terms what the features
of that particular issue are.
The objectives of bond investors range from the desire for a long term predictable cash flow (e.g. retirees,
people living off their investment income) to the desire on the part of a corporation to match a long term
obligation with a similar or identical cash inflow. For example, life insurance companies use the bond market to
match their obligations to pay policyholders (20 year obligation matched with 20 year bond).
The basic features of every bond are the face or par value, the coupon rate, the maturity, and the price.
Definitions
The face or par value of a bond is the amount that will be paid at maturity.
The par value of most bonds is $1,000 and we will assume for this course that all individual bonds repay $1,000
at maturity.
The coupon rate of a bond is the rate that determines the interest payments that will be paid at the end of every
period. The interest payments are referred to as coupon payments.
The coupon payments are usually made semi-annually (every 6 months) and the coupon rate is normally a
compounded semi-annual rate.
The maturity is the date the bond will be repaid on.
The yield rate is the rate a bond investor will earn if they hold the bond to maturity; it is usually not the same as
the coupon rate, even at the time the bonds are issued.
Yield rates reflect the market interest rate at the time the bond is purchased. Hence yield rates can change
literally from one minute to the next. The coupon rate is set before the bonds are issued and never changes.
The price of a bond is the present value of the cash flows (i.e. the coupon payments and the par value),
discounted using the yield rate.

Bond Pricing
Note that the pricing convention is to quote all bond prices using 100 as a par value, rather than $1,000. Hence
a quote of 99.583 means the $1,000 bond is trading at $995.83; a quote of 125 means it is trading at $1,250. The
$ sign is omitted from the quote and it will normally have 3 decimal places.
Consider a $1,000 five year bond, with a 4% semi-annual coupon rate, priced to yield 3% semi-annual. The par
value is $1,000, the coupon rate is 4% semi-annual, the maturity is 5 years and the yield rate is 3% semi-annual.
The investor will receive cash flows as follows:
Every 6 months for 5 years: $1,000 * 0.04/2 = $20.

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 At maturity: $1,000 (plus the final coupon)
Hence the cash flows are really an annuity of $20 every 6 months – 10 in total – and a single payment of
$1,000. The price is the present value of the cash flows, discounted at the yield rate, in this case 3% semi-
annual. Hence the price is the present value of an annuity plus the present value of a single payment and we can
use the formulas presented in Unit 1.
In this case the price will be:
PV = $20 * ((1 – (1 + .03/2)-10 )/(.03/2)) + $1,000 * (1 + .03/2)-10 = $1,046.11
Using the pricing convention mentioned above, the bond will be quoted at 104.611.
Concept Check:
What is the price of a $1,000 fifteen year bond, priced to yield 7% semi-annual if its coupon rate is 6% semi-
annual? What will the bond quote be?
The par value is $1,000, the maturity is in 15 years, the yield rate is 7% semi-annual and the coupon
payments every 6 months are $1,000*.06/2 = $30
The price of the bond is the present value of the cash flows or
PV = $30 * ((1 – (1 + .07/2)-30)/(.07/2)) + $1,000 * (1 + .07/2)-30 = $908.04
Hence the bond quote will be 90.804.

Zero Coupon Bonds

It is possible for a bond not to pay any coupons, referred to as a zero coupon bond. The price of the bond is still
the present value of the cash flows, which in this case is simply the present value of the par value - $1,000. Just
as with coupon bonds, there will be a yield rate and a maturity.
Example:
What is the price of a thirty year zero coupon bond, priced to yield 5% semi-annual? What will the bond quote
be?
The price is the present value of $1,000 to be received in 30 years at 5% semi-annual.
PV = $1,000*(1 + .05/2)-60 = $227.28
Hence the bond will be quoted at 22.728.
Concept Check
What is the price of a ten year zero coupon bond, priced to yield 10% semi-annual? What will it be quoted at?
The price is the present value of $1,000 in 10 years, discounted at 10% semi-annual.
PV = $1,000*(1 + .10/2)-20 = $376.89
The bond will be quoted at 37.689.

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Issuing Bonds
When a corporation decides to issue bonds, it approaches an investment bank to assist in finding investors for
the bonds.
The biggest bond investors in Canada are pension funds, banks, insurance companies, mutual funds and
exchange traded funds. Individual investors can purchase bonds directly but instead, they typically buy bonds
through a mutual fund or exchange traded fund (we will be exploring mutual funds and exchange traded funds
in Unit 7). The investment bank approaches these investors to see if they have an interest in buying the issuer’s
bonds and if so, what sort of yield they will demand.
The corporation needs to get the bonds rated (explained below) and needs to prepare a bond indenture. The
indenture is a legal document that will describe the bond issue in detail, including the coupon rate. The coupon
rate is set based on the investment bank’s feedback. However, there is a time lag between the setting of the
coupon rate and the bonds being issued to investors. During this time lag, interest rates can change. The interest
rate in effect at the exact time the bonds are issued will be the initial yield rate for the bonds. An example will
illustrate.
Example:
ABC Corporation wants to issue $100 million in 10-year bonds to fund a new factory they are building. ABC
has issued bonds before and those bonds were rated A. The rating agency confirms the new bonds will also be
rated A. ABC approaches an investment bank who confirms that the investment environment is such that
investors will be receptive to $100 million in bonds rated A and that the current interest rate for 10-year bonds
rated A is 2.40%. ABC prepares a bond indenture for $100 million in 10-year bonds using a coupon rate of
2.4% semi-annual.
On June 1, 2018, when ABC is ready to issue the bonds, the rate for A bonds is 2.35% semi-annual. The bonds
are issued to a group of 12 investors.
A. What will be the par value of the entire issue?
The par value of the bond issue is $100 million.
B. What will be the coupon rate?
The coupon rate is stated in the indenture and is 2.4% semi-annual.
C. What will be the maturity date?
The maturity date will be ten years from June 1, 2018, or May 31, 2028.
D. What will be the yield rate?
The yield rate is 2.35% semi-annual.
E. What will be the price of the bonds?
The price is the present value (PV) of the cash flows, discounted at the yield rate. So for a $1,000 bond,
the coupon payments will be $1,000*0.024/2 = $12
The price will be:
PV = 12*((1 – (1 + .0235/2)-20)/(.0235/2)) + $1,000*(1 + .0235/2)-20 = $1,004.43

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Hence the quote will be 100.443.
F. How much money will ABC receive prior to paying legal and other fees?
The proceeds that ABC will receive is the present value of all the cash flows associated with the entire
issue, discounted using the yield rate. The PV of the entire issue will be:
PV = $1,200,000 * (1 – (1 + .0235/2)-20)/(.0235/2) + $100,000,000 * (1 + .0235/2)-20 = $100,443,288.09
The amount of money ABC will receive is the PV of the cash flows, discounted at the yield rate or
$100,443,288.09.
Note that ABC will still repay $100,000,000.00 at maturity (and will be paying coupons of $1,200,000).
Since investors were willing to accept a lower yield rate than the expected 2.4% semi-annual, ABC
received higher proceeds at issue. If investors demanded a higher yield rate than 2.4% semi-annual, then
ABC would have received less than $100,000,000 at issue.

Concept Check
Beta Inc. plans to issue $250 million in 5-year bonds. Since the bonds will be rated BBB, Beta’s investment
bank informs them that the issue ought to be successful at a rate of 2.8% semi-annual. Beta prepares its bond
indenture using that rate. On May 1, 2019 Beta issues the bonds. Investors demand a 2.9% semi-annual rate.
A. How much money did Beta receive?
The amount of money Beta received is the PV of the cash flows, discounted at the yield rate:
The coupon payments are $250 million * .028/2 = $3,500,000
The par value is $250 million
PV = $3,500,000 * (1 – (1 + .029/2)-10)/(.029/2) + $250,000,000 * (1 + .029/2)-10 = $248,844,167.42
Beta received $248,844,167.42
B. What was the quote of the bonds at issue? Express your answer rounded to 3 decimal places.
The quote is the % of par value to 5 decimal places or
$248,844,167.42/$250,000,000 * 100 = 99.53767
The quote of the bonds at issue was 99.538.

Bonds that are issued (or trading) at less than face value are said to be issued (trading) at a discount. Bonds that
are issued (trading) at more than face value are said to be issued (trading) at a premium. So ABC’s bonds were
issued at a premium and Beta’s bonds were issued at a discount. Note that regardless of the amount of money
received at issue, the cash flows paid by the issuer over the life of the bond remain the same. In other words,
even though Beta received less than $250 million at issue, they will still repay $250 million at the end of the 5
year term.

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Since the price of the bond is the present value of the cash flows, discounted at the yield rate, the price of the
bonds has an inverse relationship with the yield rate. As the yield rate goes up, the price of the bond goes
down. As the yield rate goes down, the price of the bonds goes up.

Additional Bond Features

Thus far we have been describing a straight bond which is the most common bond. However, bonds can also
have additional features, depending on the issuer and the investing environment at the time of issue. Some
features are desirable for the issuer, and they may be willing to pay a higher interest rate to get the feature.
Similarly, some features are desirable for investors and they may be willing to accept a lower interest rate in
exchange for that feature. Examples that have been appealing in the past include:
 Secured or unsecured: a secured bond means the investor has access to other assets if the borrower
fails to pay interest or principal and therefore this reduces the risk of the investment.
 Registered or bearer: A registered bond means the owner’s name is registered with the trustee of the
bond indenture; a bearer bond means whoever is holding the bond is considered to be the owner.
 Callable: A callable bond means the issuer can repay the bond at a specified date before maturity at a
specified price. This feature could be appealing to the issuer if they expect interest rates to go down in
the short or medium term. In that case, they would call the bonds and replace them with bonds carrying
a lower interest rate. The issuer must pay for this feature by offering a higher coupon rate.
 Retractable: A retractable bond means the investor can sell the bond back to the issuer at a specified
date before maturity at a specified price. The investor might like this feature if they expect interest rates
to rise in the short to medium term; they could then sell the bonds back to the issuer and re-invest the
proceeds at a higher interest rate. The investor must pay for this feature by accepting a lower coupon
rate.
 Extendible: An extendible bond means the investor can extend the maturity date to a specified date
beyond the original maturity date. The investor might desire this feature if they are expecting interest
rates to drop over the term of the bond; if interest rates are lower at maturity, they can extend the life of
the bond and thus continue to receive the higher rate. The investor must pay for this feature by
accepting a lower coupon rate.
 Convertible: A convertible bond means the investor can convert the bond into the common shares of
the issuer at or beyond a specified date, at a specified conversion ratio. For example, each $1,000 bond
is convertible into 100 common shares. This is the investor’s option – if they don’t convert, they will
receive the coupons on time and par value at maturity. Note that the conversion ratio translates into a
higher price than the stock is trading at when the bonds are issued. In this example, the stock might be
trading at $6 when the bonds are issued. Since each $1,000 bond converts into 100 common shares, it
would not make sense for any bondholder to convert the bond into shares unless the price rose above
$10 ($1,000/100). If the stock rose to $15 say, the investor could convert each $1,000 bond into 100
common shares and immediately sell them for $1,500. The investor might desire this feature if they view
the shares as somewhat attractive; they receive interest payments on their investment but if the stock
appreciates, they can increase their return. The investor must pay for this feature in the form of a lower
coupon rate.
 Floating rate: A floating rate bond means the issuer pays a floating interest rate rather than a fixed rate
of interest over the life of the bond. Floating just means the rate will change periodically when a
benchmark rate changes. The most common benchmark is the LIBOR rate mentioned above. So a

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 floating rate bond that paid LIBOR + 1.2%, means the rate will change whenever LIBOR changes, and
the full rate paid will be 1.2% over the LIBOR rate.
 Real return bonds: A real return is the return after taking into account the effect of inflation. For
example, if you invest $1,000 for a year and earn 7%, your return before inflation is $70. If inflation is
running at 3%, goods that cost $1,000 a year ago now cost $1,030 ($1,000*(1+.03)). So your real
return is only 3.88% (i.e. $1,070/$1,030). A real return bond means the investor will earn a fixed real
return, accomplished by adjusting the par value of the bond for inflation. For example, if the real rate is
4% annual and inflation is at 1.2% annual, the $1,000 par value of each bond would be increased to
$1,012 ($1,000 * (1+.012)) and the interest payment for that year would be $1,012 * 4% = $40.48.

Concept Check
1. A callable bond and a straight bond issued by the same company have the same maturity dates and pay the
same coupons. Which will be trading at a higher price?
a) Callable bond
b) Straight bond
The callable bond benefits the issuer so the investor must be compensated in the form of a higher yield. If
the yield rate is higher the price will be lower. Hence the straight bond will be trading at the higher price.
2. A convertible bond with 3% semi-annual coupon rate and 2 years until maturity is convertible into 20
common shares of the issuer. The shares are trading at $65. Should a rational investor convert the bonds into
common shares?
a) Yes
b) No
Yes – the bond converts into 20 common shares which can be sold for $1,300 – quite a bit more than the
maturity value of the bond and the remaining 4 coupons (total $1,060). As an aside, note that the
convertible bond would be trading very close to this value.
3. A one-year zero coupon bond is priced to yield 5% semi-annual. An investor holds the bond to maturity.
Inflation over the year was 2.3% annual. What was the investor’s real return?
The price of the zero coupon bond was $1,000*(1+.05/2)-2 = $951.81
Goods that cost $951.81 a year ago now cost $951.81*(1+.023) = $973.70
Hence the investor’s real return was $1,000/$973.70 – 1 = 2.70%

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Assessing Default Risk
Investors in bonds expect the bond’s cash flows (coupon payments and principal repayment) to be paid on time.
The risk that the payments will not be made is referred to as default risk. Bond investors typically rely on bond
rating agencies and their own credit analysts to assess default risk. They will then demand certain protections in
the bond indenture, to reduce the default risk to a level they are comfortable with.
Bond Ratings
The price that bonds trade at in the market depends to a large part on the bond’s rating. A bond rating is the
opinion of a bond rating agency on how creditworthy the issuer is. The agency is hired by bond issuers prior to
issue so that the investors can assess the default risk for any particular bond. The three main rating agencies are:
Standard & Poor’s (S&P), Moody’s, and the Dominion Bond Rating Service (DBRS). They award ratings as
follows:

DBRS S&P Moody’s Comments

AAA AAA Aaa Extremely strong capacity to pay principal and interest
AA AA Aa Very strong capacity to pay principal and interest
A A A Strong capacity to pay principal and interest
BBB BBB Baa Adequate capacity to pay principal and interest
BB BB Ba Debt from CC to BB is regarded as somewhat speculative.
B B B BB is least speculative; CC is most speculative
CCC CCC Caa Large uncertainties or major risk exposures exist
CC CC Ca
C C C Income bonds – no interest being paid
D D D Debt is in default

The ratings BBB and above are referred to as investment grade. Ratings below BBB are referred to as high
yield or junk bonds.
The rating determines the interest rate that the company must pay in order to attract investors. Obviously the
highest rated issuers pay the lowest rates. When trading in the market, bonds with the same rating should trade
at the same yield rate.
For an easy to read description of how Standard & Poor’s rates companies see:
http://regulationbodyofknowledge.org/wp-content/uploads/2013/03/StandardAndPoors_Corporate_Ratings_Crit
eria.pdf
Credit Analysis
In addition to looking at a bond’s rating, bond investors will also assess the default risk by performing their own
credit analysis. In evaluating a company, many analysts refer to the four C’s of Credit: capacity, collateral,
covenants and character.
 Capacity refers to the borrowers’ ability to meet current obligations and to take on additional debt.
 Collateral refers to any assets that provide security for the debt.
 Covenants are additional features of the debt that protect lenders and allow the lender to take action
before all is lost.

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  Character refers to the character of the senior management and the culture of the company – almost
always a matter of judgment.
In Unit 5 – Financial Statement Analysis – we detail the use of financial statements to analyse a company.

Protecting Against Default Risk

Once the investor has come to a conclusion on the level of default risk, they may decide they need additional
protection in the bond indenture.
Bond indenture provisions that protect bondholders from default risk include the following:
 Sinking funds: This is a fund that an issuer must contribute to every year (usually on the coupon
dates) in an amount sufficient to repay the debt at maturity. The fund invests in fixed income
securities. The issuer does not have access to the fund for any other purpose. A similar alternative is
to require the issuer to repurchase a certain amount of bonds every year in the open market, thus
reducing the risk of default on the final payment.
 Serial bonds: Instead of the entire bond issue maturing on a single date, the issuer staggers maturity
dates (e.g. 10% is due after one year, 10% after two years, etc.), thus reducing the repayment burden
and associated risk of default at the end.
 Subordination of future debt: This refers to a restriction on the issuer’s ability to issue more debt,
since additional debt increases risk. It can either call for any future debt to rank behind the existing
bond issue in a liquidation, or it can be an outright prohibition on issuing any more debt.
 Dividend restriction: This refers to the ability of the issuer to pay dividends, either restricting them
to a certain amount, a certain class (e.g. preferred shares) or prohibiting them entirely.
 Collateral/Security: As mentioned previously, these are assets of the firm that the bondholders can
sell in the event of default.
 Financial covenants: These are financial ratios that the issuer must meet on an ongoing basis.
Typically they are indicators of failing financial health – declining profits, cash flows, etc. If the
issuer is unable to meet a covenant, the bond issue is in default and investors can demand immediate
repayment. They protect investors since there is a far greater likelihood of recovering the full
amount of the issue when the company is still operating than there is if the company has declared
bankruptcy.

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