An indenture is a legal contract. A bond indenture is a contract attached with a bond between the issuer and the bondholder. It typically involves a third-party guarantor such as a financial institute or bank that acts as a trustee.
A bond indenture specifies the terms and conditions of the bond. It legally binds both parties on either side of the bond.
Bond Indenture
A bond indenture is a legal contract binding the bond issuer and bondholder. It includes the specific terms and conditions of the contract such as the interest rate, tenure, collateral, purpose of issue, and obligations of both parties.
Since it is a legal contract, we can expect both parties to arrange it through a trustee. A bank or financial institute can act as a trustee for both parties. The bond indenture will also include specific terms and covenants attached for both parties.
How Does it Work?
Large businesses, financial institutes, and governments issue bonds to raise capital. The issuer of the bond defines a legal contract attached with the bond. The terms and conditions of a bond indenture are not specific to an individual party, since bonds are marketable securities.
It will include the specifications of the contract that define the bond characteristics. For example, if it is a secured bond, it will state the collateral attached to the bond. If the issuer fails to return the investment on maturity, the bondholder will have the right to pledged collateral assets.
Components of a Bond Indenture
A bond issuer nominates a trustee, usually a bank or financial institution. The bond indenture is regulated by the Securities Exchange Commission (SEC) in the US.
Since it is a regulated and legal contract, a bond indenture can have several formal components.
Purpose: The bond issuer must define the purpose of issuing the bond. The investors must know where the money will be spent.
Interest Rate: It is the interest rate on the face value of the bond. It is the profit calculation for the investor.
Face Value: It is the nominated face value of the bond at which it will be issued. A market value is different once the bond is issued.
Maturity: It is the expiry date of the bond at which it matures. The bond issuer must repay the investor the full amount of the bond investment on this date.
Payment Intervals and Dates: Bonds can pay interest payments in different intervals. The indenture must define the interest payment intervals and dates.
Call Option: The issued bond can be called or non-callable. It means the issuer of the bond can call the bond and payback the investor to settle the transaction at any time. A non-callable bond cannot be settled by the issuer before maturity.
Call Protection Period: It is the minimum period in which the bond cannot be called or redeemed by the bond issuer.
Non-Payment: This section includes the detailed actions that can be taken against the bond issuer if it fails to make the interest or refund payments to the bondholder. Regulators can take several actions against the bond issuer. A non-payment on interest usually ends in a penalty or revised higher interest rates.
Collateral: Secured bonds are backed by collateral. Unsecured bonds do not offer any collateral. The collateral can change the interest charged on the bond as an unsecured investment can be riskier and investors will demand higher returns.
Covenants: Bond indentures may include certain covenants for the bond issuer. These are binding conditions for bond issuers to maintain creditworthiness and funds management for interest payments to the bondholders.
Advantages of Bond Indenture
A bond indenture is a legally binding contract between the bond issuer and the bondholder. It is regulated by the SEC and a trustee oversees the process. Thus, it offers several benefits to both parties:
- It legally binds all stakeholders in the Bond issuance process. All conditions specified in the contract legally apply to all stakeholders.
- It clearly defines the features of a bond such as interest rate, maturity, collateral, and payment schedule.
- It defines the roles and responsibilities of all stakeholders in the bond indenture.
- Investors can feel secure with indentures, specifically when it comes to covenants for the bond issuer.
- A bond indenture makes the instrument marketable and tradable.
Disadvantages of Bond Indenture
Bond indentures are useful for all parties involved in the process. It can have some limitations as well:
- Indentures are issued by the bond issuer without addressing the bondholder.
- Indentures once issued cannot be altered or changed.
- They are non-transferable contracts.
Conclusion
Bond indentures are legal contracts that bind all stakeholders. It defines the features of a bond as well as the terms and conditions. It secures the interests of all stakeholders with bond issuance.
