Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

Content of a Bond Indenture

Content of a Bond Indenture

Bond Indenture

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

Collaterals are assets or guarantees that a lender accepts as security for a bond above and beyond the issuer’s promise to pay. Collateral backing serves to increase the credit quality of a bond and is one of the factors considered when determining the payable interest rate. In the event of a winding up, secured bonds or debts rank higher than unsecured debts.

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). Thus, in the event of default, bondholders/trustees cannot go after the sponsor’s other assets. The SPV is also ‘bankruptcy remote’ because it is immune to any possible financial strain suffered by its sponsor. Securities issued by the SPV are known as asset-backed securities.

Covered Bonds

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 the cover pool and the financial institution.

Bond Trustee

In certain situations, the bondholder may have difficulties determining whether the issuer is abiding by the outlined contractual obligations, also known as covenants. For instance, a stipulation could bar 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 them. 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 or 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).

bond-trustee

Other covenants that may be outlined in the indenture include actions such as:

  • timely payment of interest and 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; and
  • regular submission of comprehensive “status” reports to the trustee to evaluate compliance with the indenture.

Credit Enhancement

Bonds can also have credit enhancements that improve the bonds’ credit quality 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 (over-collateralization), or establishing a reserve account that the issuer can use 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.

Question

Samsung’s subordinate bonds offer no collateral. These bonds are most likely:

  1. Secured.
  2. Unsecured.
  3. Overcollateralized.

Solution

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.”

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep


    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.