Explain the bond indenture and the part a corporate trustee plays under it.
The idea
The bond indenture is the legal contract between the issuer and the bondholders. It sets out the terms of the issue, namely principal, coupon, maturity, security, call and sinking fund provisions, and the covenants. Affirmative covenants say what the issuer must do, such as pay interest on time, keep insurance and deliver financial statements. Negative covenants restrict the issuer, for example limits on additional debt, liens, dividends or asset sales. A corporate trustee, usually a bank or trust company, acts for the bondholders as a group. It holds the indenture, monitors compliance and enforces the terms. Before default its duties are limited to those written in the indenture. After an event of default it must act with the care of a prudent person. The trustee is paid by the issuer but owes its duties to holders, and it does not guarantee payment.
A practice question
What is a bond indenture?
- A rating agency report that summarises an issuer's creditworthiness for investors.Why not: Confuses the indenture with a credit rating report.
- The contract between issuer and bondholders that sets the bond's terms. - correct
- A summary of the bond's terms sent to investors by the underwriter in the offering document.Why not: Confuses the indenture with the prospectus or offering circular, which is a marketing and disclosure document.
- An agreement between the issuer and the underwriters on how the bond will be distributed.Why not: Confuses the indenture with the underwriting agreement, which governs distribution, not the rights of holders.
The indenture is the contract between issuer and bondholders covering the terms (principal, coupon, maturity, security) and covenants. A trustee enforces it on behalf of holders.
A harder one
Which pair correctly classifies two typical covenants in a bond indenture?
- Maintaining insurance on the issuer's assets is a negative covenant; limiting additional debt is an affirmative covenant.Why not: Swaps the classifications: what the issuer must do is affirmative, what it may not do is negative.
- Both are affirmative covenants, because they protect the bondholders.Why not: Classifies by purpose; the categories depend on whether the issuer must act or must refrain.
- Maintaining insurance on the issuer's assets is an affirmative covenant; limiting additional debt is a negative covenant. - correct
- Both are negative covenants, because both limit the issuer's freedom.Why not: Treats any obligation as a restriction; a duty to act (such as insuring) is an affirmative covenant.
Affirmative covenants require actions (pay interest, insure assets, deliver financial statements). Negative covenants restrict actions (additional debt, liens, dividends, asset sales).
The hardest tier
Which statement about the trustee's position in a distressed issue is most accurate?
- It is paid by the issuer and so must follow the issuer's instructions after default.Why not: Equates who pays the fee with who the trustee serves; it serves bondholders.
- It is paid by the issuer but owes its duties to bondholders and guarantees nothing. - correct
- It has the right to alter the coupon and maturity without holder approval to avoid default.Why not: Gives the trustee power to amend economic terms; such changes need holder consent.
- It becomes the legal owner of the bonds and receives their proceeds after default.Why not: Confuses the trustee with a holder; it acts for holders, it does not own the bonds.
The trustee's fee comes from the issuer but its duties run to bondholders. It enforces the indenture and passes funds on; it does not guarantee payment, rate the bonds or own them.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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