A bond indenture is a contract between a bond issuer and a bondholder. The bond indenture specifies the terms of the bond, such as the bond’s maturity date, coupon amount, and payment frequency. The bond indenture also identifies any assets used as collateral for the bond issuance.
Bonds can be structured with various features, which are outlined in the bond indenture. For example, some bonds can be convertible into other corporate securities, such as common or preferred stock. The bond indenture specifies the circumstances in which these bond may be converted.
Another feature of certain bonds is callability. Callability refers to the issuer’s ability to redeem the bonds from the bondholders. Issuers do this when interest rates fall, and it may be beneficial to redeem the current bonds outstanding and issue new bonds at a lower rate. Not all bonds are callable. Because callability poses reinvestment risk to the bondholders (in that they have to reinvest the proceeds at a lower rate), callable bonds usually offer a slightly higher interest rate than noncallable bonds.
One highly important section in the bond indenture contains the bond covenants. Covenants are restrictions to the issuer placed within the bond indenture. There are two kinds of covenants: affirmative (positive) covenants and restrictive (negative) covenants. Affirmative covenants are requirements which specify things the issuer must do, such as maintaining assets in working condition, maintaining certain levels of insurance, and regularly reporting financial statements. Restrictive covenants prohibit or limit the issuer from taking certain actions, such as paying dividends or making acquisitions.
