Bond agreements or indentures are legal contacts between the issuing company and debt holders that specify the interest rate and term of the bond issue. The agreement also protects the interests of investors who own the debt by limiting certain actions by the issuing company. Companies that violate the agreements in an indenture are in technical default and can be forced to return the principal that is owed to a bondholder. Bond agreements are important because fixed-income investments are generally considered less risky than other investments, and these indenture agreements limit the risk of the bond investment.
Issuance of New Debt
Most indenture agreements restrict the ability of the company to issue new debt that is senior or equal to the debt that is already issued. If a company liquidates or goes into bankruptcy, this feature protects existing bondholders from a claim on the company's assets that is superior to it. Bondholders are not worried about claims from stockholders because bonds rank higher in the capital structure than the claims of either common or preferred stockholders.
Other restrictions prohibit the company from issuing more debt, even if the new debt is junior to an existing issue, unless it meets certain financial covenants that establish financial strength. An example would be maintaining a minimum net worth, or limiting the debt issuance if it exceeds a multiple of net worth. This would keep the issuing company from leveraging itself too highly.
Bond indenture agreements usually contain a provision that limits the issuing company from paying dividends to common and preferred stock holders above a set amount. This protects the bondholders from having cash paid out that might be needed as collateral in case of a default by the issuing company. A related provision would prohibit an issuing company from paying a dividend to stockholders if the company is unable to pay interest on its debt.
Collateral is an asset that is pledged by a borrower as a condition of a loan. Bond indenture agreements will list certain assets that the issuing company owns that are considered collateral for the bondholders. The agreement will prohibit the issuing company from selling that collateral without the permission of the bondholders. A related provision might specify that if the collateral were sold, then the funds received would be put into an escrow account and reserved for the bondholders.
Bond agreements were mandated by a federal law passed in 1939 called the Trust Indenture Act. The law specified that any bond issue in an amount over $5 million had to be accompanied by a written agreement outlining the terms of the bond issue.
A unusual modern feature contained in some bond agreements are pay-in-kind clauses, which allow issuers to pay interest due in more bonds rather than cash. This is known colloquially as a "toggle bond," implying that an issuer can switch from cash to non-cash payments.
Characteristics of Bonds
Bonds are among the most important and widely traded of all securities. Investors value bonds and bond funds for their income and...