Explain what a bond indenture is and the positive and restrictive covenants in it
The idea
The indenture is the legal contract between issuer and bondholders, administered by a trustee acting on the holders' behalf. Affirmative covenants state what the issuer must do — pay interest and principal on time, maintain its properties, supply audited financial statements. Negative covenants state what it must not do: incur debt beyond a stated ratio, pledge assets to other lenders, sell major assets, or pay dividends above a limit. Negative covenants are the ones that protect value, because they prevent the issuer from transferring wealth to shareholders after the money has been lent.
A practice question
What is the role of the trustee under a bond indenture?
- To guarantee repayment of principalWhy not: The trustee enforces the contract but stands behind none of it. Repayment depends on the issuer.
- To act on behalf of the bondholders in enforcing the indenture — correct
- To set the coupon rate at each payment dateWhy not: For a floater the reference rate is observed from the market, not set by anyone. For a fixed-rate bond the coupon is fixed at issue.
Dispersed holders cannot each negotiate with an issuer. The trustee is the mechanism through which their collective rights are exercised.
A harder one
Which is a negative covenant?
- A limit on additional borrowing beyond a stated leverage ratio — correct
- A requirement to supply audited financial statementsWhy not: An obligation to act, which makes it affirmative.
- A requirement to maintain insurance on pledged propertyWhy not: Also an obligation to act. Both are things the issuer must do rather than must not.
Negative covenants restrict what the issuer may do. The other two are affirmative obligations to act.
The hardest tier
Why do negative covenants do more to protect bondholders than affirmative ones?
- Because they are enforced by regulators rather than the trusteeWhy not: Both kinds are enforced through the trustee under the indenture. Regulators are not party to it.
- Because they carry higher penalties for breachWhy not: Breach of either can trigger the same remedies. The difference is in what is being prevented, not in the consequence.
- Because they prevent the issuer transferring value to shareholders after the debt is issued — correct
Once lent, the money is at risk from decisions the issuer takes later — a large dividend, a leveraged acquisition, pledging assets elsewhere. Affirmative covenants describe good housekeeping; negative ones block the transfers that actually destroy recovery.
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