What is the difference between a positive and negative covenant?

What will be an ideal response?

There are two general types of covenants. Positive (or affirmative) covenants call upon the corporation to make promises to take certain actions. Negative (or restrictive) covenants differ because they require that the borrower not take certain actions. There are an infinite variety of restrictions that can be placed on borrowers in the form of restrictive covenants. More details are given below on these restrictive covenants.

Some of the more common restrictive covenants include various limitations on the company's ability to incur debt since unrestricted borrowing can be highly detrimental to the bondholders. Consequently, bondholders may want to include limits on the absolute dollar amount of debt that may be outstanding or may require some type of fixed charge coverage ratio test. The two most common tests are the maintenance test and the debt incurrence test. There could also be cash flow tests (or cash flow requirements) and working capital maintenance provisions.

Some indentures may prohibit subsidiaries from borrowing from all other companies except the parent. Indentures often classify subsidiaries as restricted or unrestricted. Restricted subsidiaries are those considered to be consolidated for financial test purposes; unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded from the covenants governing the parent. Often, subsidiaries are classified as unrestricted in order to allow them to finance themselves through outside sources of funds.