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, which is 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, which includes 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.
Because the value of a bond depends on the creditworthiness of the issuer, indentures usually include protective covenants (aka restrictive covenants) that restrict the issuer from doing things that would make it less creditworthy, 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:
- pay the interest and principal of its bonds
- specify when bonds can be presented for payment
- maintain the collateral in good condition
- insure the collateral against loss
- defend the legal title to the property
- pay all taxes and assessments, including property, income, and franchise taxes (otherwise, tax authorities can place a lien on the businesses property that is superior to that of other creditors, even secured creditors)
- maintain the business to ensure that the business can continue as a going concern, including maintaining the corporate structure and the right to do business
The 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 would 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 lower yield. Hence, the degree of protection for bondholders is inversely related to the bond yield— more protection, less yield, and vice versa. This is congruent with the general principle that the greater the risk of the security, the greater its yield must be to entice investors.
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 price — the call premium — that will be paid if called. Generally, a bond cannot be called before a certain date, and the call premium is usually more than par value at earlier dates, but diminishes as the bond approaches maturity.
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 is 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 have less financial wherewithal at end of the term to repay the principal and interest, 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:
- only a specified portion of the issue can be retired in any given year,
- 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; the disadvantage is that they are less liquid.
Subordination of Debt
Although bonds are generally 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, almost all 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 the amount of stock dividends that can be paid, if the earnings of the company are less than a specified amount, since the payment of stock dividends lessens the equity of the company, and may impair its ability to make future interest payments 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 bonds from than same issuer that is backed by collateral. 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.
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. As a consequence, many companies have added 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.
Quick Profits by Forcing Bond Defaults Because of Late Filing of Reports
WSJ.com - 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.