Bond Indentures and Covenants

Bond Indentures

A bond indenture is a legal contract that outlines the obligations of the bond issuer and the rights of the bondholders. It’s often referred to as the bond indenture. This contract lays the groundwork for all subsequent transactions between the bondholder and the issuer. Beyond defining the issuer’s obligations and restrictions, the bond indenture also details the bond’s features. It pinpoints the issuer’s sources of repayment, commitments made to bondholders, and provisions that enhance the issuer’s capacity to fulfill its debt obligations in full.

Sources of Repayment

Repayment sources for bonds differ based on the issuer. National governments often leverage their sovereign right to tax economic activities. In contrast, local or regional governments might derive repayment funds from taxation or fees associated with infrastructure projects. Corporate bond investors predominantly depend on the firm’s operating cash flows. Meanwhile, Asset-backed securities (ABS) are anchored in the cash flows generated from a collection of loans or receivables held by a designated special-purpose issuer.

Bond Covenants

Covenants are provisions in the bond indenture. They are legally enforceable rules that borrowers and lenders agree upon when a bond is issued.

Negative Covenants (Restrictions)

Negative covenants, often termed as restrictions, primarily aim to safeguard the interests of bondholders. They act as preventive measures, ensuring that the issuing firm refrains from actions that could escalate the risk of default. Examples of such covenants include restrictions on asset sales, negative pledges of collateral, limitations on further borrowings, and constraints on investments, disposal of assets, or the issuance of debt that is senior to existing obligations.

Affirmative Covenants (Promises)

Affirmative covenants, also known as promises, are actions that the borrower commits to undertake. Unlike negative covenants, they do not typically curtail the operational decisions of the issuer. Examples include making punctual interest and principal payments to bondholders, ensuring and upkeeping assets, adhering to relevant laws and regulations, utilizing the proceeds from the bond issue appropriately, providing financial reports in a timely manner, allowing bondholders the option to redeem their bonds at a premium if the issuer undergoes acquisition, and clauses like the pari passu, which guarantees equal treatment of debt obligations. Another notable affirmative covenant is the cross-default clause, which signifies a default if the issuer defaults on any other debt obligation.

Contrasting Affirmative and Negative Covenants

Affirmative Covenants are actions that the borrower promises to perform. They are typically administrative in nature and do not usually impose additional costs on an issuer nor materially constrain the issuer’s discretion in operating its business. On the other hand, negative covenants are prohibitions on the borrower. They are designed to protect bondholders by preventing the issuer from taking certain actions that might increase the risk of default. However, they should not be so restrictive that they hinder the issuer from capitalizing on opportunities or adapting to changing business circumstances.

Question #1

What is the primary purpose of a bond indenture?

1. To specify the bond’s features and identify the issuer’s sources of repayment.
2. To provide a detailed history of the issuer’s past financial performance.
3. To outline the voting rights of bondholders in the issuer’s annual general meeting.

Solution

The correct answer is A.

A bond indenture is a legal contract that outlines the obligations of the bond issuer and the rights of the bondholders. It specifies the bond’s features, the issuer’s sources of repayment, and other commitments and provisions.

B is incorrect: The bond indenture does not provide a detailed history of the issuer’s past financial performance; it focuses on the terms and conditions of the bond.

C is incorrect: Bondholders typically do not have voting rights in the issuer’s annual general meeting; that privilege is reserved for equity shareholders.

Question #2

Which of the following is least likely a source of bond repayment?

1. Operating cash flows of the firm for corporate bonds.
2. Fees from infrastructure projects for local governments.
3. Dividends from equity shares.

The correct answer is C: Dividends from equity shares are returns to equity shareholders and are not a source of bond repayment.

A is incorrect: Investors in corporate bonds rely on the operating cash flows of the firm as their primary source for interest and principal payments.

B is incorrect: Local or regional governments may use fees from infrastructure projects as a source of bond repayment.

Question #3

Which of the following is most likely the primary role of negative covenants in a bond indenture?

1. To specify actions that the borrower promises to perform.
2. To ensure that an issuer maintains the ability to make interest and principal payments.
3. To provide bondholders with voting rights in the issuer’s decisions.

Solution

The correct answer is B.

Negative covenants are prohibitions on the borrower. They are designed to protect bondholders by preventing the issuer from taking certain actions that might increase the risk of default.

A is incorrect: This describes affirmative covenants, which specify actions the borrower promises to perform.

C is incorrect: Bondholders typically do not have voting rights in the issuer’s decisions; that privilege is reserved for equity shareholders.