A Brief Introduction About the Bond Indenture
What Is a Bond Indenture?
A bond indenture is a legal contract between the bond issuer and the bondholder.
As per the indenture definition, it has all details of the terms and conditions relating to the bonds. Information like the maturity date, the frequency of interest payment, and their calculation. Any special features can also be found in the agreement.
These agreements are incredibly technical as they have to provide not only the provisions of the bond but how it is managed on a daily basis.
Apart from the above information, these agreements will also guide the bondholders when the bonds are called or repurchased and will have all the relevant information regarding how to tender your certificate and receive your principal amount. The regulations that the bonds are governed by are also mentioned.
To ensure that the bond issuer is abiding by all the rules, making the principal and interest payments on time or distributing the bond certificates as required, a trustee who is appointed by the issuer to protect the interest of the bondholder.
Who Takes the Bond Indenture? – People Involved
There are two parties to an indenture, the bondholder and the bond issuer.
The bond is issued to the trustee, not the bondholder. The trustee could be a bank or financial institution which ensures that the bond issuer does not deviate from the terms and conditions mentioned in the agreement.
Purpose of a Bond Indenture – Why Do You Need It?
You need an indenture because the issuer of a bond is basically taking a loan from the bondholder promising to pay them interest at a certain rate over a specified period of time.
The bondholders are investing their money with the expectation that they will have a steady flow of income for a given tenure, and at the end of the tenure, their principal invested will be returned to them.
If there is a verbal agreement between the two parties, then the bond issuer can default in the payment of principal as well as interest. The bondholder will not have any legal recourse as there are no legal documents to prove that they have given a loan to the bond issuer and are entitled to earn interest on the same. This would make lending money to the company a very risky proposition.
In order to protect the interest of the bondholder, it is very important to have such an agreement. The bonds are issued to a trustee who ensures that the bondholder’s investment is safe. In the event of a default, the bondholder can take the bond issuer to court and claim the dues as well as the legal costs.
Contents of Bond Indenture – Inclusions
A bond indenture will include information related to the rights and obligations of the bondholder and the bond issuer.
An indenture agreement will contain the following information:
- Parties to the agreement: The agreement will include the name of the bondholder and the bond issuer
- Eligibility of the bond issuer: The legal status of the bond issuer and permission granted by the regulatory authority to issue the bonds
- Communication address: The registered office address of the bond issuer including all contact information
- Rights of the bondholder: The rights of the bondholder should be stated with regard to receiving interest payments on time and principal payment on maturity of the bond
- Interest or coupon rate: The interest or coupon rate at which the interest will be paid to the bondholder. The method of calculation of interest rates must be mentioned
- Due date of interest payment: The due date by which the interest payment must be made
- Trustee: The name of the trustee appointed by the bond issuer, including the registered address and registration details. The trustee has to ensure that the covenants are followed, the interest is paid on time, and the certificates are distributed and collected properly
- Governing regulations: The regulations which govern the issue of the bonds have to be included
- Special features: There could be zero-coupon bonds or variable rate bonds
- Certificates: The detailed description of the certificates
- Financial covenants: The covenants to be followed by the bond issuer
- Language: The language in which the bond has been written
How to Draft a Bond Indenture?
Points to Consider While Preparing the Agreement
While drafting this agreement, the following points need to be kept in mind:
- Bond issuer: The details of the bond issuer including the authorization by the concerned regulatory authority to issue bonds
- The effective date of the agreement: The date from which the agreement is active
- Governing law: The laws of the state where the agreement is being drafted relating to the issue of the bonds
- Face value: The face value of each bond being issued
- Coupon rate: The coupon rate of the bond including whether they are fixed or variable in nature
- Bondholder: The name and address of the bondholder
- Number of bonds: The total number of bonds being issued by the bond issuer and their value
- Covenants to be followed: The covenants which require to be followed in this type of bond issue
- Rights and obligations: The rights and obligations of both parties to the agreement
- Qualifications of the trustee: The background of the trustee needs to be verified to ensure that they are qualified and competent to act as a trustee
- Calling of bonds: When the bonds are called, the procedure to tender their certificates
- Maturity amount: The method by which the maturity amount will be returned to the bondholder
Negotiation Strategy
Before entering into this indenture, the bondholder needs to verify the background of the company or institution issuing those bonds. Bonds are usually rated by certain agencies to indicate the ability of the issuer to repay the principal and interest on time.
If the ratings are low, indicating the possibility of default, the bondholder can either choose not to invest or negotiate a higher rate.
Benefits & Drawbacks of a Bond Indenture
The benefits are as stated below:
- Protection of interest: The interest of the bondholder with respect to the timely payment of interest and principal on maturity is ensured with the agreement. If the bond issuer fails to do so, then the bondholder can take legal action against the bond issuer
- Fixed obligation: The bond issuer knows that the coupon payout over the tenure of the bond will be fixed
- Shareholder’s equity: There is no dissolution of shareholder’s equity with the issue of bonds
- Regular income: The bondholder is assured of a regular income over a fixed period of time, even if general interest rates fluctuate
The drawbacks of a bond indenture are:
- Penalty for default: The bond issuer will have to pay the penalty if there is even a single default in payment of either the coupon rate or the principal
- Possibility of default: Even if the bond has been highly rated by a reputed rating agency, there is a possibility of default on the part of the bond issuer. In this case, both the principal and interest rates are at risk. Recovery would be extremely difficult if the bond issuer is bankrupt.
- Lack of flexibility: While a fixed payout is beneficial for the bondholder, the bondholder may be at a disadvantage during a period of falling interest rates
What Happens in Case of Violation?
A bond is a promise by the bond issuer to pay the bondholder the coupon rate mentioned in the bond at a given frequency.
The bondholder loans a certain sum of money with the understanding that the principal invested will be returned on maturity, and the interest payment will be paid on the due dates, which will be a regular source of income.
The bond issuer appoints a trustee to safeguard the interest of the bondholder. It is the duty of the trustee to ensure that all the financial covenants laid down the concerned regulatory authority with regard to issuing of bonds are followed by the bond issuer.
Even if the trustee monitors the bond issue to protect the bondholder’s interest, it is possible that the financial condition of the bond issuer deteriorates, resulting in default of principal and interest. This is a violation of the agreement, and the bondholder can take the bond issuer to court. Instead of individual action, bondholders have to take action against the bond issuer as a class or group.
It is therefore advisable that the bondholder verify the background of the bond issuer by consulting a financial advisor with regard to the present financial condition of the company as well as check the rating awarded to the bond issue.
A bond is an efficient way for a company to raise capital. The company does not need to dilute the shareholder’s equity, and it has a fixed payout to the bondholders over a certain period of time at the end of which the bondholder’s invested principal needs to be returned.
The bondholder is also benefited as they have a regular income from the bonds at a certain frequency and return of the principal on maturity.
A bond indenture is laid down the rights and responsibilities of both parties, and the interest of the bondholder is managed by a trustee. All the details regarding the type of bonds issued(1), the tenure and the coupon are mentioned.
However, the financial condition of the company may be adversely affected during the tenure of the bond. It would also affect the payment of interest and principal. Bondholders should assess the financial condition of the company through professional advice before investing in a bond.