What is a Closed-End Indenture
A closed-end indenture is a term in a bond contract that guarantees that the collateral used to back the bond issue cannot be used again to support another bond issue. A closed-end indenture makes the bond, an already low-risk investment, even less risky for the investor. The type of indenture of a bond affects risk. Invoking the indenture happens if the issuer defaults on the bond. Therefore, this term is more important the less stable an issuer is.
In contrast, an open-end indenture is one in which single collateral can back more than one bond.
BREAKING DOWN Closed-End Indenture
A closed-end indenture is one small but crucial detail regarding a bond that affects the risks to the bond for both issuer and 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.
The yield-to-maturity rate is not listed in the conditions of the bond because it is assumed to be the prevailing market interest rate at the time of issue. Terms contained in the indenture include:
- The face value is the nominal, or dollar value, of security stated by the issuer. For bonds, it is the amount paid to the holder at maturity, generally $1,000. It is also known as "par value" or simply par.
- An interest rate or coupon rate is the yield paid by a which is just the annual coupon payments paid by the issuer relative to the bond's face or par value.
- Dates of interest payment is a component of the total loan contract. It represents the dollar amount required to pay the interest cost of the loan for the payment period.
- The maturity date is 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 who administers the bond is a financial institution with trust powers, such as a commercial bank or trust company, that is given fiduciary powers by a bond issuer to enforce the terms of a bond indenture.
- Bond redemption and early redemption terms include the return of an investor's principal in fixed-income security.
- Collateral is property or other assets which a borrower offers as a way for a lender to secure the 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.
Closed-End Indenture and Stability of the Bond Issuer
Closed-end or open-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. The fewer claims that exist on the collateral, the more safety a bondholder has.
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 might 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 id stable has more confidence that they will not default and can therefore 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.