When an investor thinks of bonds, they often think about the financial agreement between the investors and the borrowers. However, besides being financial instruments, bonds are also legal in nature.

Each and every fixed-income security which is in existence has a contract that defines the rights and obligations which various parties have under different circumstances. Over the course of time, bond agreements have become standardized. This is the reason why a lot of investors just assume that the legal factors remain constant across various types of bonds. However, this may not necessarily be the case. These legalities are often referred to in the covenants and the indenture of the bond. In this article, we will understand the concept of covenant and indenture in more detail.

What is a Covenant?

A bond covenant is a legally binding agreement that restricts the behavior of the firm borrowing money. This is generally done to ensure that the borrowing firm does not continue to recklessly borrow more and more money until it goes bankrupt. Covenants have been designed to restrict the actions of the borrowing firm. There are legal penalties that have been designed to penalize companies that refuse to comply.

For instance, a company may sign a covenant that it will always ensure that its debt to equity ratio does not go beyond 1:1. In such cases, if a firm fails to comply with this covenant, it may have to face financial losses and even liquidation!

It is important to realize that covenants can be both positive as well as negative. This means that some covenants are created in order to ensure that the company refrains from taking certain actions.

On the other hand, some other covenants have been designed to incentivize firms to take certain actions. For instance, borrowing firms may have to sign an undertaking that will ensure that the assets being used as collateral have adequate insurance.

Many times, covenants used may be non-financial in nature. They can be related to issues such as full disclosure and good faith which are often implied. However, when firms sign the dotted line, they become legally obliged to follow these principles.

Since covenants restrict the actions of the borrower, it is no surprise that many borrowers in the financial world do not like to issue bonds with restrictive covenants. However, based on the market situation at the time of issuance of bonds, they are often forced to agree to restrictive terms. There are many issuers in the bond markets who are willing to pay a premium in order to ensure that they do not have to comply with restrictive covenants.

What is an Indenture?

As mentioned above, specific clauses which restrict the action of the issuer are known as covenants. Individual items are known as covenants. However, the entire set of covenants is collectively known as an indenture. An indenture is a specialized form of agreement between the issuer and the investors. This agreement clearly outlines the rights and duties of every party involved in the transaction.

Restricted Vs Unrestricted Subsidiaries

Modern corporations are made up of several subsidiaries. This means that corporations can use their corporate structure to evade the restrictions imposed by the covenants. For instance, firms could agree to restrictive covenants on one subsidiary while at the same time, they may continue to borrow aggressively from a different subsidiary.

However, this is usually not the case. Bond investors nowadays pre-empt this issue by asking issuers to clearly mention restricted as well as unrestricted subsidiaries. Restricted subsidiaries are those on which the covenant and indenture of the issuing firm become applicable. Unrestricted firms are those on which the terms mentioned in the covenant and indenture are not applicable.

Issuing firms have a choice to designate each subsidiary as either restricted or unrestricted. However, if a subsidiary is designed as unrestricted, then the issuing firm cannot include its cash flows and earnings in order to increase its eligibility to borrow more money.

If a company designates one of its subsidiaries as unrestricted, then that subsidiary is treated as a third party. This means that all transactions with that subsidiary are considered to be transactions done with an external party.

Recourse to Investors

Bond covenants are considered to be extremely crucial since they give investors several powers. If investors find bond issuers to be in violation of the covenant and the indenture, they can take one of the following several actions.

• Lenders can demand penalty payments that may have been agreed upon in the indenture

• Lenders could be entitled to an increased coupon rate because of the increased risk

• Lenders could demand that more collateral be submitted so that the overall riskiness of the bonds once again comes within the prescribed limits

• Lenders could also demand partial or full repayment of the outstanding principal. If the borrowing firm does not have the money to honor the contract, lenders could force liquidation of the firm.

The fact of the matter is that bond covenants and indenture are to be taken very seriously. They form the very basis on which the bond agreement is structured. It also has a huge impact on the manner in which the bonds are valued.