IFT Notes for Level I CFA® Program
R39 Fixed-Income Securities: Defining Elements
2. Bond Indenture
A bond is a contractual agreement between the issuer and the bondholders. In this section, we will discuss the following:
- Bond indenture (trust deed).
- Legal and regulatory considerations.
- Tax considerations.
2.1 Bond Indenture
Given below are a few terms related to bonds which we should remember:
Trust deed or bond indenture: A written legal agreement between the bond issuer and the investor. The indenture has the following information:
- The name of the issuer.
- All the terms of a bond issue such as the type of bond.
- Its features such as the principal value, coupon rate, dates when interest payments will be made, and maturity date.
- Issuer’s obligations.
- Bondholders’ rights.
- If the bonds are secured or not.
- Contingency provisions like call option.
Collateral: Are assets or financial guarantees offered by the issuer for the underlying debt issue. This is in addition to the promise to pay interest and principal. It is like a security for the investors if the bond issuer (or borrower) fails to make payments.
Credit enhancement: Provision used by a company to improve its creditworthiness or reduce the credit risk of a bond issue.
Covenant: Clauses that state what an issuer can and cannot do; includes restrictions imposed on the issuer such as raising more capital to protect the bondholders. Specifies the rights of bondholders.
Assume a company such as General Electric announces a $1 billion bond issue. Millions of investors will invest in the issue. It is practically impossible for the company to enter into a legal contract with each one of them, so it entrusts the fiduciary responsibility of the issue to an intermediary called the trustee. The trustee is appointed by the issuer.
The trustee is a financial institution, like the trust department of a bank. The trustee holds the indenture. Its duties are primarily administrative in nature like invoicing the issuer for interest and principal payments, holding funds until they are paid, calling meetings of bondholders, ensuring the issuer adheres to the terms stated in the indenture, etc. If the issuer defaults, the role of the trustee becomes significant.
In addition to a bond’s features, an investor must review the following aspects (especially his rights in case of a default):
- Legal identity of the bond issuer and its legal form.
- Source of payment proceeds.
- Asset or collateral backing.
- Credit enhancements.
Legal Identity of the Bond Issuer and its Legal Form
The bond issuer has the legal obligation to pay the interest and principal. The issuer is identified in the indenture by its legal name. Investors must understand who is issuing the bond.
- For a sovereign bond, it is the entity responsible for managing the national budget such as HM Treasury in the United Kingdom.
- For a corporate bond, it is the corporate legal entity such as Wal-Mart Stores Inc., Volkswagen AG, etc.
- Some companies are structured in a way that there is a holding company at the top, under which there are many operating/group companies. Bonds may be issued by the holding company, a parent company, or a subsidiary. It is important to evaluate the credit risk of the company for which bond is being issued rather than the issuer.
- In case of securitized bonds, the sponsor has the legal obligation to pay the bondholders. Sponsor is the financial institution in charge of the securitization process.
Source of Repayment Proceeds
Investors need to know how the issuer intends to make interest payments and repay the principal. The bond indenture specifies the source of revenue or how the issuer intends to make interest and principal payments. We look at the repayment sources for each category now.
- For supranational bonds: From repayment of previous loans or paid-in capital from its members. For example, the World Bank may have given a loan to a particular country. When the country pays back the loan, this money is used to pay the bondholders. Paid-in capital is the amount contributed by member nations.
- For sovereign bonds: Tax revenues and printing new money. The government may also increase taxes to service debt.
- Three sources for non-sovereign government debt issues: the taxing authority of the issuer, cash flows of the project, special taxes or fees.
- For corporate bonds: Cash flow generated by the company’s primary operations. The higher the credit risk, the higher the yield.
- For securitized bonds: Cash flows generated by the underlying assets such as mortgages, credit card receivables, auto loans, etc. Securitized bonds are amortized, i.e., the principal is paid back gradually over the bond’s life rather than in one payment at maturity.
Asset or Collateral Backing
Collateral reduces credit risk.
- Secured vs. unsecured bonds: In a secured bond, assets are pledged as collateral to ensure debt repayment in the case of a default. Unsecured bonds have no collateral.
- Seniority ranking: What this means is that if a company faces bankruptcy and its assets are liquidated, the investors (or bondholders) are repaid based on seniority.
- Debentures: It is a type of bond that may be secured or unsecured. In most countries, debentures refer to unsecured bonds. However, in some countries like the United Kingdom and India, they are backed by collateral.
Bonds can be classified into the following based on the type of collateral backing:
- Collateral trust bonds: Bonds that are secured by a financial asset such as stocks and other bonds. They are deposited by the issuer and held by the trustee.
- Equipment trust certificates: Bonds secured by physical assets or equipment such as railroad cars, aircraft, or oil rigs.
- Mortgage-backed securities: They are backed by a pool of mortgages. The interest and principal payments from the mortgages are used to pay the bond-holders. We will see this in detail in the subsequent readings.
- Covered bond: Debt securities that are backed by a “cover pool” of assets such as mortgage loans or public sector loans. In some ways they are similar to securitized bonds such as MBS, but they offer a greater degree of protection.
Credit Enhancements (if any)
Credit enhancements are provisions used to reduce the credit risk of a bond issue using additional collateral, insurance, or third-party guarantee. These are usually used for securitized bonds. When credit risk is reduced, it increases the issue’s credit quality and decreases the interest rate of the bond. There are two types of credit enhancements: internal and external.
Internal credit enhancements: No external instrument is used in this case to increase the credit quality.
- Senior/junior: In this structure, debt is segregated into different tranches with different priority based on seniority. The cash flows generated from the assets are allotted to these different tranches accordingly with the senior tranche getting paid before the junior tranches. The subordinate or junior tranches offer credit protection to the senior tranches.
- Overcollateralization: The process of posting more collateral than is required, to obtain financing. The value of the asset pledged as collateral exceeds the value of the loan.
- Excess spread: It is the difference between the interest rate received on the underlying asset, and coupon rate paid to investors. The excess amount is deposited into a reserve account which is used to absorb losses on assets. It is also called excess interest cash flow.
External credit enhancements: Relies on a third party called a guarantor, to provide a guarantee.
- Surety bonds/bank guarantees: A bond that guarantees to pay the investor if the issuer defaults. It is similar to a bank guarantee but issued by an insurance company.
- Letter of credit: It is a document or a letter from a financial institution, typically a bank. It guarantees the payment of interest and principal to investors if the issuer is unable to pay.
Covenants (if any)
Note: This section is important and explicitly stated as a learning objective.
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. Covenants can be affirmative (positive) or negative (restrictive). Affirmative covenants indicate what the issuer must do. These are generally administrative in nature. They do not impose additional costs on the issuer. For example, the issuer must:
- Make interest and principal payments on time.
- Comply with all laws and regulations.
- Maintain current lines of business.
- Insure and maintain assets.
- Pay taxes on time.
- Other examples include a ‘pari pasu’ clause which ensures that a debt obligation is treated the same as the borrower’s other senior debt instruments, or a ‘cross-default’ clause which specifies that a borrower is considered in default if they default on another debt obligation.
Negative covenants indicate what the issuer must not do. These are frequently costlier and materially constrain the issuer’s potential business decisions. Examples include:
- Restrictions on debt: Limits on maximum acceptable leverage ratios and minimum acceptable interest coverage ratios.
- Negative pledges: No additional debt can be issued that is senior to existing debt.
- Restrictions on prior claims: The issuer cannot collateralize assets that were previously collateralized. The objective is to protect unsecured bondholders.
- Restrictions on distribution to shareholders: Restrictions on how much money can be spent on dividends and buy-backs.
- Restrictions on asset disposals: A limit on the total amount of assets that can be disposed during a bond’s life. The objective is to ensure the company does not breakup.
- Restrictions on investments: This ensures no investment is made in a speculative business and that the capital is invested in a going-concern business.
- Restrictions on mergers and acquisitions.