What Is a Closed-End Indenture?
The term closed-end indenture refers to a bond contract that guarantees that the collateral used to secure the bond cannot be used again to support another bond issue. An indenture is a legal and binding provision usually associated with bond agreements, real estate, or bankruptcy cases.
A closed-end indenture makes the bond even less risky for the investor. Invoking the indenture happens if the issuer defaults on the bond.
- A closed-end indenture ensures that a bond's collateral is not used to support another bond issue.
- Due to this restriction on the use of collateral, closed-end indentures are comparatively less risky.
- In the event of default, this indenture's collateral would pay back those bondholders.
How Closed-End Indentures Work
Bonds are generally considered to be among the safest investment options available to investors. They are conservative investments that provide investors with stability and income. They represent loans advanced by the investor to the bond issuer—the issuer promises to repay the investor the principal balance invested along with any interest payments by a specified date. Put simply, a bond is an IOU that the issuer gives to the investor.
All bonds have contracts, called indentures, outlining the terms of the bond. Indentures are legally binding and unconditional, and the penalty for breaking them is severe. A closed-end indenture is a clause that involves the use of collateral that backs the bond. This type of indenture is a small but crucial detail regarding a bond that affects the risks to the bond for both the issuer and investor. As mentioned above, the collateral used cannot be used to issue any new bonds.
Closed-end indentures are only invoked if the bond issuer defaults, which means that indenture is crucial in a situation of financial instability for the bond issuer. If the bond issuer defaults, a closed-end indenture ensures the bondholders will have the only claims on the collateral, making their bonds the most senior security. Fewer claims on the collateral mean more safety for the bondholder.
The yield-to-maturity (YTM) rate is not listed in the conditions of the bond because it is assumed to be the prevailing market interest rate at the time the bond is issued. Terms contained in the indenture include:
- The face value: Also known as the par value, this is the nominal value of a security. For bonds, it is the amount paid to the holder at maturity, generally $1,000.
- The interest rate or coupon rate: This is the yield paid by a fixed-income security.
- Interest payment date: This is a component of the total loan contract which represents the dollar amount required to pay the interest cost of the loan for the payment period.
- The maturity date: The day the borrower is required to repay the full amount of the outstanding principal plus any applicable interest to the lender. Nonpayment at maturity may constitute a default.
- The name of the bond trustee: A financial institution that administers the bond. It has both trust and fiduciary powers granted by an issuer to enforce the terms of the indenture.
- Bond and early redemption terms: These include the return of an investor's principal in a fixed-income security.
- Collateral: An asset offered by a borrower to a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. Collateral is either an open-end indenture or a closed-end indenture.
The yield-to-maturity rate is omitted from a bond's conditions because it is assumed to be the prevailing market interest rate when the bond is issued.
Closed-End Indentures vs. Open-End Indentures
Both closed-end or open-end indentures may be invoked if the issuer of the security defaults. But there is a slight difference between these two clauses. An open-end indenture is one in which a single piece of collateral can back more than one bond. This means an open-end indenture bond could have any number of bonds with the same collateral used to back up the security, so in the event of a default, an investor may have no possibility to claim that collateral if another investor has a senior claim on the collateral.
A less stable bond issuer has more incentive to include an open-end indenture term in the bond offering. An issuer who is stable has more confidence that they will not default and can thus add a closed-end indenture in the bond's terms. Indenture can be used by an investor—along with interest rate and time to maturity—to assess risk and make a decision about investing in a specific bond issue.