Bond Indentures

A bond is a security issued to a lender, the bondholder, for a loan in the amount of the bond's price. To issue a bond, a 3rd-party trustee, usually a bank or a trust company, is assigned by the issuer to serve the needs of the bondholders, including bringing suit in the event of a default. The bond indenture (aka trust indenture, deed of trust) is a legal contract between the issuer and the trustee that specifies the scope and the responsibilities of the borrower, the trustee, and the lender, and the characteristics of the bond, such as the maturity date, and the coupon rate. The indenture, a copy of which must be filed with the Securities and Exchange Commission (SEC), is required by the Trust Indenture Act of 1939 for issues registered under the Security Act of 1933, including most corporate bonds, but not for issues for less than $5,000,000, municipal bonds, and bonds issued by governments.

The indenture will specify, among other things, the interest rate, the date of maturity, the procedures to modify the indenture after issuance, and the purpose of the bond issue. The name and contact information of the trustee will be listed in the indenture. If the bond has coupons, the indenture will specify where the coupons can be presented for payment.

Protective Covenants

Because the value of a bond depends on the creditworthiness of the issuer, indentures usually include protective covenants (aka restrictive covenants) restricting the issuer from doing things that would lower its credit rating, which would lower the bond's price in the secondary market, and increase the chance of default in interest payments or principal repayment.

Protective covenants usually provide at least the following provisions:

Protective covenants are a compromise between what the issuer wants and what the bond buyers want. Issuers want to pay the minimum interest with the least restrictions in their freedoms, while bond buyers want the highest interest with those restrictions that would maintain the creditworthiness of the issuer. The bond issuer willingly adds restrictions, however, since the bonds would sell for a higher price (lower yield). Hence, the degree of protection for bondholders is inversely related to the bond yield— more protection, less yield, and vice versa, congruent with the general principle that greater risk requires a greater yield to entice investors.

Callable Bonds

The indenture will specify whether the bond is callable, and if it is, it will specify the conditions under which it can be called, including the dates when it is callable, and the call price, or the call premium, that will be paid if called. A bond cannot be called before a certain date (call date). The call premium is usually more than par value at earlier dates, but diminishes as the bond approaches maturity. Most bonds can be called at any time after the call date.

Sinking Funds and Serial Bonds

When a bond is issued, the issuer generally pays interest over the term of the bond, then repays the principal and the last interest payment when the term ends. This can be a large amount of money that must be paid some time well into the future, which constitutes a risk that the company may be unable to repay the principal and interest at end of the term, so some companies establish a sinking fund, which retires a stipulated number of bonds at par value at specified time intervals. If interest rates have risen since issuance, causing the bond prices to drop below par value, then the company will purchase the bonds in the secondary market. If, however, interest rates have fallen, then the company will pick the specified number of bonds at random to retire by paying par value to the bondholder. Though similar, the retiring of a sinking fund bond differs from a call on a bond in 2 ways:

  1. only a specified portion of the issue can be retired in any given year,
  2. and the bondholder only gets par value, whereas most callable bonds, especially if they are called early, pay a call premium above par value that usually decreases with the number of years before it is called.

Some bonds, called serial bonds, especially those backed by hard assets that depreciate, such as equipment trust certificates, are issued with serial maturities — a certain proportion of the issue matures in successive years. The advantage of serial bonds over sinking-fund bonds is that the term of the bond is known with certainty; but they are less liquid.

Subordination of Debt

Although bonds are considered safe investments, they wouldn't be that safe if the company could issue more debt afterwards without restriction. More debt would decrease the issuer's creditworthiness, which would cause all its bonds to decrease in price in the secondary market, and would greatly increase risk to current bondholders. Therefore, most indentures include subordination clauses that limit the amount of additional debt that the issuer can incur, and all subsequent debts are subordinated to prior debts. Thus, the 1st bond issue is called senior debt, because it has priority over subsequent debt, called junior debt or subordinated debt. If the issuer goes bankrupt, senior debtholders get paid before junior debtholders.

Restriction of Stock Dividend Payments

A bond indenture may also restrict stock dividends that can be paid, if the earnings of the company are less than a specified amount, since the payment of stock dividends lowers the cash available to pay future interest and repay principal.

Debentures and Collateral

A bond issued without collateral backing it is called a debenture — an unsecured bond. The bond's safety is determined by the creditworthiness of the issuer. Because these bonds are riskier, they pay a higher yield than collateralized bonds from the same issuer. If the issuer defaults, then the holder of a debenture is a general creditor of the issuer, but if the bond is backed by collateral, then the collateral is sold, or used, to pay the collateralized bondholders.

Collateral bonds can be classified according to the type of collateral. A collateral trust bond (synonym: collateral trust certificate) is a bond backed by other securities owned by the issuer, but held in trust by the trustee. Mortgage bonds are backed by real estate, and equipment obligation bonds, also called equipment trust certificates, are backed by equipment. Railroads and other transportation companies usually issue equipment trust certificates — the collateral can easily be sold to other companies in the same industry.

Special Features

Some bonds have special features. Convertible bonds, for instance, can be converted into the common stock of the issuer, or put bonds can be sold back to the issuer before maturity for par value. The indenture will list the details of these special features, including the dates when the special features will be available, and under what conditions. For convertible bonds, for instance, the conversion ratio or conversion price will be specified, which determines the number of shares of stock the bond can be converted to.

Leveraged Buyouts Increase Risks for Bondholders — Change of Control Covenants

Private equity firms and management companies have been buying companies through leveraged buyouts (LBOs), which uses the acquired company's cash flow to pay debt used to acquire the company. This can cause the credit rating of the company to drop to junk status and the prices of its bonds to drop. Consequently, many companies add a change of control covenant (aka poison-pill covenant) to the bond indentures that either limits the amount of additional debt that the company can take on, or the company must buy back the bonds, sometimes at a slight premium, when a change of control occurs. Some companies add a put option to its bonds so that bondholders can sell the bond back to the company at par value before maturity. For instance, Expedia sold 12-year bonds with a put option that allowed bondholders to turn in the bond after 7 years for par value.

In addition, some companies have been trying to issue covenant-lites, or pay-in-kind toggle bonds, which would allow the issuer, if financially distressed, to issue more junk bonds in lieu of interest payments to bondholders. This would allow the company to circumvent covenants that restrict additional debt to its free cash flow.

How to Find Bond Indentures

Bond indentures are not as readily available as other financial information. However, in most cases, you will never have to consult the indenture because most bond listings will also list most of the important information about a bond, including whether it is callable and the earliest call date.

You can find some bond indentures at the SEC Edgar database, which can be freely searched online:

In some cases, you may have to contact the issuer to get a copy of the indenture if you need more detailed information than what is provided by bond listings.


Quick Profits by Forcing Bond Defaults Because of Late Filing of Reports - Hedge Funds Play Hardball With Firms Filing Late Financials

A standard indenture requirement is that bond issuers must send quarterly and annual reports to bondholders by a specified time, about when it files those reports with the SEC. Most companies have 60 days after the missed deadline to file the reports. Failure to do so is a technical default.

Now that bonds prices are lower because of higher interest rates, a quick profit can be made by buying bonds at a discount, forcing a default which forces the company to pay par value for the bonds immediately, or pay a fee or offer better terms to bondholders as compensation.

These so-called vulture investors are using this method to take advantage of companies caught up in the options backdating scandals, which has caused their bond prices to drop in the secondary market.