Contents of a Bond Indenture | CFA Level I Fixed Income

Welcome to the second part of our introduction to fixed income! In this lesson, we’ll discuss the contents of a bond indenture.

Trust Deed and Bond Indenture

The trust deed, also known as the bond indenture, is a legal contract that outlines the bond’s structure, issuer’s obligations, and bondholder’s rights. A trustee, typically a financial institution, is appointed to ensure the issuer complies with the indenture and to take action on behalf of bondholders when necessary.

Issuer and Types of Bonds

Bonds can be issued by various legal entities, and it’s crucial for bondholders to know who is responsible for making interest and principal payments. The three main sectors where bonds are issued include:

• Government sector (sovereign bonds)
• Corporate sector (corporate bonds)
• Structured finance sector (securitised bonds)

Source of Repayment Proceeds

Sovereign bonds are backed by the “full faith and credit” of the national government, relying on tax revenues and money-printing abilities. Corporate bonds depend on the company’s cash flows, while securitised bonds rely on the cash flows generated by the underlying assets.

Collaterals, Secured and Unsecured Bonds

Collaterals are assets pledged to ensure debt repayment in case of default. Secured bonds have specific assets pledged as collateral, while unsecured bonds have only a general claim on the issuer’s assets and cash flows. Unsecured bonds can be senior or junior (subordinated), with senior bonds having priority over junior bonds during liquidation.

Debenture: The term “debenture” has different meanings in different countries. In the US, it refers to unsecured debt, while in the UK, it refers to secured bonds. Investors should review the indenture to determine whether a debenture is secured or unsecured.

Asset-Backed Securities (ABS) and Covered Bonds

Asset-backed securities (ABS) are securities with cash flows from specific assets set aside for bondholder payments. These assets are usually sold to a bankruptcy-remote Special Purpose Vehicle (SPV). If the originating firm goes bankrupt, the assets are protected from the firm’s creditors. However, if the backing assets fail to perform, ABS holders have no recourse from the originating firm.

Covered bonds, common in European countries, are similar to ABS but with the underlying assets remaining on the originating firm’s balance sheet. These assets are protected from the firm’s creditors by special legislation. If the assets fail to perform, the originating firm must replace or augment the non-performing assets, providing protection to the covered bondholders and often lowering the required yield on the bonds.

Debt Covenants: Affirmative and Negative

Debt covenants are legally enforceable rules agreed upon by borrowers and lenders when a bond is issued, generally to protect the lender’s position. Covenants can be:

• Affirmative covenants – borrower promises to do certain things
• Negative covenants – borrower promises to refrain from certain activities