Final answer:
A protective covenant is a clause in a bond indenture that limits actions of the corporation to protect bondholders' interests by ensuring the company's ability to repay them.
Step-by-step explanation:
A protective covenant is a part of the bond indenture that serves to safeguard bondholders by restricting the corporation's actions. These covenants are critical in ensuring that the corporation does not engage in behaviors that could jeopardize its ability to make payments to the bondholders. An example of a protective covenant might be a restriction on the amount of additional debt the company can take on or requirements for maintaining certain financial ratios. Protective covenants can include restrictions on the corporation's ability to take certain actions, such as incurring additional debt, selling assets, or paying dividends. By imposing these limitations, the bondholders are given some level of protection and assurance that the corporation will fulfill its obligations to them.
Such covenants are crucial for the risk management of bond investments. Even though bonds issued by reputable corporations or the U.S. government are often considered low risk, protective covenants provide an additional layer of security. They ensure that bond issuers do not make choices that increase the likelihood of bankruptcy, which could affect their capability to meet obligations to bondholders.