A bond indenture is a legal document that outlines all the parameters of the bond issue, such as the par amount, issuer, coupon rate, security pledge, and the rights of bondholders. When analyzing a bond, it is important to review the credit risk of the issuer – the entity legally obliged to repay the bondholders. The indenture will also describe the security ranking of the bonds, which can be secured or unsecured. Secured bonds grant bondholders a claim on a specific asset while unsecured, or debentures, offer no collateral and are repaid after secured bonds.
Collaterals are assets/guarantees that a lender accepts as security for a bond above and beyond the issuer’s promise to pay. Collateral backing serves to increase a bond’s credit quality and is one of the factors considered when determining the interest rate payable. In the event of a winding up, secured bonds/debt rank higher than unsecured debt.
Some of the items often used as collateral include physical equipment, mortgages, and stocks.
Legal Identity of the Bond Issuer and its Legal Form
It’s important to identify the issuer of a bond by its legal name. The investor must understand who the issuer is. The issuer can be:
- A subsidiary of a parent legal entity;
- A holding company; or
- A special purpose vehicle (SPV), with a separate legal entity, set up to issue bonds. Such bonds are secured by assets that have been hived off the entity’s sponsor (i.e., removed from the sponsor’s balance sheet). In the event of default, bondholders/trustees cannot go after the sponsor’s other assets. The SPV is also ‘bankruptcy remote’ in the sense that it is immune from any possible financial strain suffered by its sponsor. Securities issued by the SPV are known as asset-backed securities.
Covered bonds are securities issued by a bank or mortgage institution and collateralized against a pool of assets. Unlike asset-backed securities, covered bonds offer more protection to the bondholder since the pool of assets remains on the financial institution’s balance sheet. In the event of default, bondholders have recourse against both cover pool and the financial institution.
In certain situations, the bondholder may have difficulties trying to ascertain whether the issuer is abiding by the outlined contractual obligations, also known as covenants. For instance, there could be a stipulation that bars the issuer from issuing similar bonds for a specified period of time. For this reason, the bondholder may enlist the services of a trustee who acts in a fiduciary capacity for the bondholder. The trustee is usually a third party with trust powers, such as the trust department of a bank. A summary of the trustee’s duties may include:
- Monitoring to ensure that the issuer complies with the obligations specified in the indenture;
- Taking action on behalf of the bondholder, e.g., in the event of a winding up of the issuer;
- Maintaining/holding the required documentation and records;
- Invoicing the issuer for interest payments and principal repayments;
- Holding funds in transit (until they are paid to the bondholder).
Other covenants that may be outlined in the indenture include actions such as:
- Timely payment of interest/principal
- Payment of taxes and other regulatory fees as may be required
- Keeping acquired assets in good condition
- Limitation on the sale of assets
- Limitations on dividend payouts and share repurchases
- Regular submission of comprehensive “status” reports to the trustee so as to evaluate compliance with the indenture
Bonds can also have credit enhancements that improve the credit quality of the bond and reduce the interest costs to the issuer. An internal credit enhancement ranges from distinguishing bonds based on the level of seniority compared to other debt obligations, providing more collateral than is needed for the bonds (overcollateralization), or establishing a reserve account that can be used by the issuer if they have insufficient funds to repay bondholders. An external credit enhancement is generally an insurance product that may take the form of a surety bond, letter of credit, or a cash collateral account.
Samsung’s subordinate bonds offer no collateral. These bonds are most likely:
The correct answer is B.
Unsecured bonds offer no collateral and are repaid after secured bonds. Instead, the issuer promises that they will be repaid. This promise is frequently called “full faith and credit.”
Reading 42 LOS 42b:
Describe the content of a bond indenture