I wouldn't say that covenants fundamentally change the functionality of Bitcoin in terms of smart contracts. All they can do is place conditions on the spending of a UTXO. Bitcoin's "smart contracts" are not in the same category as Ethereum's: they are processed statelessly, there is no interaction between Bitcoin smart contracts. Even if Bitcoin script was replaced with a Turing complete language, these limitations still apply, and they keep Bitcoin safer and more decentralized. I don't see any layer 2 getting around these limitations, but sidechains might be able to, with the caveat of tradeoffs in the security.