A trust indenture is an agreement in a bond contract made between a bond issuer and a trustee that represents the bondholder's interests by highlighting the rules and responsibilities that each party must adhere to. It may also indicate where the income stream for the bond is derived from.
Breaking Down Trust Indenture
Bonds are issued to lenders or investors to raise money for a corporation or governmental body. To issue a bond, the issuer hires a third-party trustee, usually a bank or trust company, to represent the interests of its bond investors. The agreement entered into by the issuer, and the trustee is referred to as the trust indenture.
A trust indenture is a legal and binding contract that is created to protect the interests of bondholders. The trustee’s name and contact information is included in the document, which highlights the terms and conditions that the issuer, lender, and trustee must adhere to during the life of the bond. The section on the trustee's role is important, as it gives a clear indication of how unforeseen incidents will be dealt with. For example, if a conflict of interest comes up involving the trustee's role as a fiduciary, in certain trust indentures, the issue must be resolved within 90 days. Otherwise, a new trustee will be hired.
A trust indenture also includes the characteristics of the bond, such as maturity date, face value, coupon rate, payment schedule, and purpose of the bond issue. One section of the trust indenture dictates the circumstances and processes surrounding a default. The indenture establishes a collective action mechanism under which creditors or bondholders can collect in a fair, orderly manner if default takes place. A bondholder should be aware of these situations because understanding the proper sequence of events will allow them to take the proper course of action if a default occurs.
Protective or restrictive covenants are highlighted in a trust indenture. For example, a trust indenture may indicate whether an issued bond is callable. If the issuer can “call” the bond, the indenture will include call protection for the bondholder, which is the period during which the issuer cannot repurchase the bonds from the market. After the call protection period, the indenture may list the first call dates and any subsequent call dates that the issuer may exercise its right to call. The call premium, that is, the price that will be paid if the issuer repurchases the bond is also indicated on the trust indenture.
Almost all indentures include subordination clauses that limit the amount of additional debt that the issuer can incur, and all subsequent debts are subordinated to prior debts. Without such restrictions, bondholders will be exposed to default risk if an issuer is allowed to issue an unlimited amount of debt.
A copy of the indenture must be filed with the Securities and Exchange Commission (SEC) for corporate bonds with aggregate principal issues of at least $5 million. Corporate issues for less than $5 million, municipal bonds, and bonds issued by the government are not required to file trust indentures with the SEC. These exempted entities may choose to create a trust indenture to reassure prospective bond buyers, not to adhere to any federal law. Also, trust indentures may not be included in every bond contract, given that some government bonds disclose similar information (the duties and rights of the issuer and bondholders) in a document called the bond resolution.