Covenants are restrictions written into bond and loan contracts either limiting or encouraging the borrower's actions that affect the probability of repayment.

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Question restatement: Covenants are restrictions written into bond and loan contracts either limiting or encouraging the borrower's actions that affect the probability of repayment.

Option 1: True. This statement aligns with standard definitions in debt financing. Covenants are indeed contractual provisions that limit or require certain borrower actions (such as debt incurrence, asset sales, dividend payments, or financial ratio targets) to protect lenders by influencing the likelihood of repayment. Therefore, this option correctly captures the essence of covenants.

Option 2: False. This would be incorrect because covenants are not merely decorative clauses; they are enforceable provisions designed to curb riskier borrower behavior and influence repayment probability. Saying covenants do not affect repayment probability overlooks their primary risk-management purpose and typical content.

Rationale across options: The core concept is that covenants constrain or direct borrower behavior with the aim of maintaining financial health and reducing default risk. If a statement claimed covenants have no impact on repayment probability, it would contradict their function and practice in credit agreements. Conversely, acknowledging that covenants are limitations or incentives—depending on the clause—accurately reflects their role in governance of debt covenants and lender protection.

FINS5530-Financial Institution Mgmt - T3 2025

Covenants are restrictions written into bond and loan contracts either limiting or encouraging the borrower's actions that affect the probability of repayment.

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