Final answer:
Protective covenants in bond contracts are designed to protect bondholders from decisions by the issuer that could affect their investment negatively.
Step-by-step explanation:
The primary purpose of protective covenants associated with bonds is to protect bondholders from issuer actions that can potentially harm their interests. These covenants are terms included in the bond contract to ensure that the issuer adheres to certain guidelines or restrictions that reduce the risk of financial loss for the bondholders. For example, covenants may limit the amount of additional debt the issuer can take on, which could compromise their ability to make interest payments or repay the bond's principal at maturity. Protective covenants serve as a mechanism to safeguard the bondholder's investment by imposing conditions on the issuer's activities.
When reviewing bond investments, an investor will look at these covenants as one aspect that influences the overall risk of the investment. The presence of strong protective covenants can make a bond more attractive, potentially leading to a lower interest rate risk, since these covenants provide a higher degree of certainty that the issuer will act in a manner that preserves the value of the bond.
In summary, protective covenants actively serve to protect bondholders from decisions made by the issuer that could jeopardize the return on their investment or the safety of their principal.