What is a Bond Indenture?

The bond indenture usually includes:

• The purpose of the proceeds of the bond issue and its features, such as coupons and interest payment dates
• Conditions under which the bonds may be redeemed before maturity, also known as callability
• Covenants or promises that the borrower makes with respect to its behavioral, legal, and financial obligations over the life of the bond
• The description of the flow of funds, prioritizing the use of incoming revenue as it pertains to both the project and the payment to investors
• Procedures and remedies should the issuer default
• Rights and duties of the trustee

The indenture will contain several protective covenants. These are limitations agreed to by the borrower to protect the investor from a deterioration of value and default. A review of these covenants is important for evaluating the borrower’s credit risk.

The bond issuer must appoint an independent trustee, usually a bank or trust company, to authenticate the bonds and ensure that the issuer complies with all of the indenture’s covenants.

Example:

A borrower issues a bond financing to fund a project. The project’s revenues will be used to pay the investors their principal and interest payments, that is, the debt service payments. The bond indenture could state that the holder has to put a specific amount of money in escrow to be used should the project’s revenue not cover the debt service payments.

What’s important here?

The bond indenture sets many of the rules the borrower must abide by in order to stay out of either technical default or default.