Bond indentures and covenants

What does a bond indenture contain?

The indenture is the legal contract behind a bond. It describes the form of the bond, the issuer’s obligations and the bondholders’ rights. It holds the features from the previous lesson, names the sources of repayment, lists any support for repayment, and sets the covenants.

Where does repayment come from?

The sources of repayment vary by issuer and are a key driver of risk.

Source of repaymenta key driver of a bond's risk

• Sovereign bond Memorize taxes, sometimes printing currency
• Local or regional government Use it taxes, or fees from a project (tolls, transit)
• Corporate bond Memorize operating cash flows first
  • Unsecured operating cash flows only
  • Secured operating cash flows, then a claim on named collateral
• Asset-backed security Use it cash flows from a pool of loans or receivables, paid to tranches in order

Bond	Primary source	Secondary source
Sovereign	taxes (sometimes the power to create money)	none needed; usually the highest quality in its market
Local or regional government	taxes, or fees from a project (tolls, transit)	none
Unsecured corporate	issuer’s operating cash flows	none
Secured corporate	issuer’s operating cash flows	claim on named collateral
Asset-backed security	cash flows from a pool of loans or receivables	paid out to tranches by priority

An unsecured bond relies on operating cash flows alone, which is typical for higher-quality corporate issuers. A secured bond adds a legal claim on specific assets. That claim is called a lien or a pledge , and the assets are the collateral . In liquidation, secured creditors receive the value of the collateral, and unsecured creditors share only what remains.

Collateral and guarantees are credit enhancements . They lower the issuer’s borrowing cost but reduce its operating flexibility.

For asset-backed securities (ABS), the repayment source is the cash flow from a pool of loans or receivables owned by a special purpose issuer. The pool is sliced into classes called tranches , with the senior tranche paid first. Securitization modules cover them in detail.

How are claims ranked in liquidation?

Cash from a liquidationpaid top down until it runs out

• 1. Senior secured Memorize first call on the pledged assets
• 2. Senior unsecured Memorize shares what is left
• 3. Subordinated (junior) Memorize paid only after senior claims are met

Senior secured is paid first, then senior unsecured, then subordinated (junior). Within a class, issue date does not matter.

What is the difference between affirmative and negative covenants?

Covenants are legally enforceable terms agreed when the bond is issued. Bondholders have no vote, so covenants are their main lever over the issuer.

Covenantslegally enforceable terms agreed at issue

• Affirmative (must do) Memorize mostly administrative, cheap for the issuer
  • Use proceeds as stated
  • Deliver financial reports on time
  • Pari passu clause rank equally with similar debt
  • Cross-default clause default elsewhere is default here
  • Redeem at a premium if acquired
• Negative (must not do) Memorize restrict decisions; more of them for weaker issuers
  • Limit extra debt unless a ratio test is met
  • Limit liens and pledges negative pledge
  • Limit dividends and buybacks
  • Limit asset sales, sale and leaseback, mergers

Affirmative covenants say what the issuer must do. They are mostly administrative and cheap: use the proceeds as stated, deliver financial statements on time, and let bondholders redeem at a premium if the issuer is acquired. Two others are easy to misfile. A pari passu clause (“equal footing”) ensures the bond is treated the same as the issuer’s other debt of similar rank. A cross-default clause treats the issuer as in default on this bond if it defaults on another debt. Both are affirmative.

Negative covenants say what the issuer must not do beyond set limits: take on extra debt, pledge assets to other lenders or issue debt that would rank ahead of this bond (a negative pledge clause , or limitation on liens), pay dividends or buy back shares, sell key assets, do a sale and leaseback, or merge. They protect bondholders from dilution of their claims. Weaker issuers face more of them.

Incurrence tests

An incurrence test is a ratio test that must be passed before the issuer takes a specific action, such as issuing debt or paying a dividend.

If a covenant is breached, bondholders may get a higher coupon or more security, accelerated repayment, or termination of the agreement. Covenants that are too tight can force a default that might have been avoided, for example by blocking new borrowing the issuer needs to meet its payments.

Exam tip Duties are affirmative. Limits are negative. Pari passu and cross-default are duties.

Go deeper Why secured bonds still depend on cash flows

Collateral is a fallback. Selling assets in a default takes time, often fetches less than book value and may not cover the claim. An investor in secured debt still analyzes the issuer’s operating cash flows first, because avoiding default is better than recovering from it.

Go deeper Tranches: a capital structure built from one pool

An ABS divides one pool of loans into classes with different priority. Tranche A is paid first, Tranche B next, and Tranche C only after A and B are satisfied. The result recreates a ladder like the one above, with the lowest tranche absorbing the first losses.

Go deeper Maintenance and incurrence tests

A maintenance test (the always-on cap above) must be met in every reporting period, and a breach is a violation whatever the issuer is doing. An incurrence test applies only when the issuer wants to act, so a drift in the ratio does not trigger a breach by itself. Lenders to riskier issuers often use both, and often with a looser maintenance level than the incurrence level.