What is a Bond Indenture?
Indenture refers to a legal and binding agreement, contract, or document between two or more parties. Traditionally, these documents featured indented sides or perforated edges. Historically, indenture has also referred to a contract binding one person to work for another for a set period of time (indentured servant), particularly European immigrants. In modern day finance, the word indenture most commonly appears in bond agreements, real estate deals, and some aspects of bankruptcies.
A bond indenture is a legal document or contract between the bond issuer and the bondholder that records the obligations of the bond issuer and benefits owed to the bondholder. The bond indenture also includes the details of the rights of ownership as well as the rights of the bondholder to receive interest payments and principle payments in the future.
What Does Bond Indenture Mean?
The bond indenture is created during the bond issuing process when bond issuers are receiving approval from state and federal governments to issue bonds to the public. After an agreed upon amount of bonds is authorized by the applicable government agency, the company issuing the bonds must contract a bond indenture.
Don’t get the terms indenture and debenture confused. A bond indenture is the contract between the bond issuer and the bondholder. A bond debenture is simply and unsecured bond.
The terms of a bond indenture include a description of the bond features, restrictions placed on the issuer, and the actions that will be triggered if the issuer fails to make timely payments. Thus, an indenture will likely include the following clauses:
- Purpose. The agreement states the reason why the bonds are being issued.
- Interest rate. This is the interest rate stated on the face of the bond.
- Interest calculation. This is a description of the formula used to calculate the amount of interest to be paid.
- Payment dates. The dates when interest payments will be made to bondholders.
- Maturity date. The maturity date of the bond, when the face amount of the bond will be paid to bondholders.
- Call features. This explains the rights of the issuer to buy back bonds prior to the maturity date.
- Conversion features. This is an explanation of the circumstances under which bonds can be converted into the common stock of the issuer, and at what conversion multiple.
- Covenants. This is a list of the covenants to which the issuer will be subjected while the bonds are outstanding, and how the covenants are calculated.
- Non-payment actions. This can include a number of possible actions, such as increasing the interest rate, creating a cumulative interest liability, or accelerating the maturity date of the bond.
The bond indenture is the core legal document referenced by the bond issuer and investors when there is a dispute regarding bonds.
Example
Bond indentures are not issued to individual bondholders. It would be pretty impractical for a company to try to enter into a contract with every single bondholder. That is why the bond indenture is actually issued to a trustee or third party that represents the bondholders. The trustee is most often a bank or some other financial institution. If the company breaks the agreement set forth in the bond indenture, the trustee can sue the company on behave of the bondholders.
The bondholders can also voice complaints to the trust in an effort to raise legal action against the issuing company.
Advantages
- Bond Indenture is the legal document; all the clauses mentioned in the document are applicable to all the stakeholders involved in the transaction.
- Bond Indenture protect the interest of all the stakeholders and reduce the chance of default.
- Indenture clearly defines all the information related to the bond.
- The rights and Duties of all the stakeholders are clearly defined in the Indentures that helps in avoiding any confusion.
- This document ensures all the stakeholders must be aware of the covenants for proper transparency.
- Indenture is the only legal document that is referred in case of any dispute regarding the bond.
Disadvantages
- Indentures are non-transferable; hence there are very limited options available to exit these contracts.
- These contracts, once signed, are not renegotiable, so any change in the interest rate due to policy change may have financial repercussions.
Conclusion
Bond Indenture is a core legal document that safeguards the right of both investors and issuers. It contains all information related to the bond, along with the Rights and responsibility of both issuer and bondholders. Indenture has the legal binding on all the stakeholders, and in case of any dispute or default, the indenture will be considered for any resolution.