What it means
When a company or government sells bonds to many investors, those investors cannot each negotiate with the issuer or chase it if something goes wrong. The indenture solves this by appointing one trustee to act for everyone, and by writing the terms into a single document that applies to the whole bond issue.
The document covers the basic terms, such as the principal amount, the interest rate, the payment dates and the maturity. It also contains covenants, which are promises by the issuer.
Affirmative covenants require things like paying taxes and keeping accounts, while negative covenants restrict things like taking on too much extra debt or selling key assets. It also defines events of default, such as missing a payment or breaching a covenant, and sets out the remedies.
The trustee can usually demand repayment, start legal action and share any money recovered among the holders, according to the order of payment set out in the document. Holders of a set percentage of the bonds can often direct the trustee or waive a default.
In the United States, indentures for public bond offerings above a certain size are governed by the Trust Indenture Act, which sets minimum standards for the trustee and the content of the document. Private deals and international bonds have their own rules, and the indenture is usually governed by the law of a named jurisdiction, such as New York or England.
For a finance team, the indenture is a document to read closely before issuing debt and to monitor afterwards. A breach of a financial covenant can allow bondholders to demand early repayment, so companies track their ratios against the covenant levels every quarter and talk to the trustee early if a problem looms.
In practice
Real-world examples.
Example
A manufacturer issues $200,000,000 of bonds and signs an indenture with a bank as trustee. The document requires the company to keep its debt below a set multiple of earnings and to send annual audited accounts to the trustee.
Example
A software company misses a covenant by a small margin after a bad quarter. It asks the bondholders for a waiver, pays a small consent fee of 0.25% of the bonds, and the indenture is amended to reset the limit.
Example
A city issues revenue bonds to build a toll road. The indenture says toll income must go into a separate account first and cover bond payments before it can be used for anything else.
Formula
Calculation
Interest coverage ratio = Earnings before interest and tax / Interest expense
An indenture requires the issuer to keep its interest coverage ratio at or above 3.0 times. The company reports earnings before interest and tax of $1,500,000 and interest expense of $400,000.
Interest coverage = 1,500,000 / 400,000 = 3.75 times, which is above the 3.0 requirement, so the covenant is met. If earnings fell to $1,100,000, the ratio would be 1,100,000 / 400,000 = 2.75 times, which would breach the covenant and could trigger default remedies after any cure period.Case study
Seen in the real world.
Stonebridge Freight is an illustrative, fictional company that issued $120,000,000 of 10-year bonds under an indenture with a negative covenant limiting additional debt to 4.0 times earnings. A year later a fuel price spike cut earnings, and the ratio moved to 4.3 times.
The CFO contacted the trustee before the quarterly report was due and asked for a waiver. Holders of a majority of the bonds agreed, in return for a 0.50% fee and a promise to pause dividends, which cost the company $600,000 and avoided an acceleration of the debt.
The illustrative lesson is that the indenture was a living document that needed monitoring. Stonebridge now tests every covenant each month and reports the headroom to its board, which turns a potential crisis into a routine item.
Watch out
Common mistakes.
- Treating the indenture as boilerplate that no one needs to read, when covenant breaches can trigger default.
- Assuming the trustee protects investors from losses, when its role is to administer and enforce the contract.
- Waiting until a covenant is breached to talk to bondholders, when early contact makes a waiver easier.
Questions
People also ask.
What is the difference between an indenture and a bond?
The bond is the security the investor holds, while the indenture is the contract that sets out its terms and the issuer's promises.
Who is the trustee?
Usually a bank or trust company that is independent of the issuer and paid a fee for its services.
Can an indenture be changed?
Yes, usually with the consent of a set majority of holders, though changes to core terms such as the payment date often need every affected holder to agree.
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