Fixed Income I
Reading 42. Fixed-Income Securities: Defining Elements
Learning Outcome Statements
b. describe content of a bond indenture;
c. compare affirmative and negative covenants and identify examples of each;
CFA Curriculum, 2020, Volume 5
Subject 2. Bond Indenture
Bondholders may have great difficulty in ascertaining whether the issuer has been fulfilling its obligations specified in the indenture. The indenture is thus made out to a third-party trustee as a representative of the interests of the bondholders; a trustee acts in a fiduciary capacity for bondholders.
Legal Identity of the Bond Issuer and its Legal Form
The issuer is identified in the indenture by its legal name. It is obligated to make timely payments of interest and repayment of principal. Bonds can be issued by a subsidiary of a parent legal entity. They can also be issued by a holding company. A special-purpose vehicle/entity (a separate legal entity) can issue bonds collateralized by assets transferred from its sponsor. If bankruptcy occurs, the sponsor's creditors cannot go after such assets; this is known as bankruptcy remote.
Source of Repayment Proceeds
The source of repayment proceeds varies, depending on the type of bond.
- Supranational bonds: repayment of previously loans, or the paid-in capital from members
- Sovereign bonds: taxing authority and money creation
- Non-sovereign government bonds: general taxing authority of the issuer, project cash flows, and special taxes
- Corporate bonds: the issuer's operating cash flows
- Securitized bonds: cash flows from the underlying financial assets
Asset or Collateral Backing
Collateral backing can increase a bond issuer's credit quality.
- Seniority ranking affect credit. In general, secured debt takes priority over unsecured debt if the issuer goes bankrupt. Within unsecured debt, senior debt ranks ahead of subordinated debt. Debentures can be either secured or unsecured.
- Types of collateral backing include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.
An unsecured bond is not secured by collateral.
Covered bonds are debts issued by banks that are fully collateralized by residential or commercial mortgage loans or by loans to public sector institutions.
Credit enhancement reduces credit risks. Internal credit enhancement considerations include:
- Tranche structure. The senior tranches get paid first, and the subordinated tranches get paid only if there are enough funds left. The subordinated tranches absorb the credit risk, making the senior tranches less risky.
- Overcollateralization. The amount of overcollateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral's value is $105 million, then the first $5 million loss will not result in a loss to any of the tranches.
- Excess spread. Underlying assets support a higher level of payment than that promised to security holders.
External credit enhancements are financial guarantees from third parties. Examples include surety bonds, bank guarantees, and letters of credit. If the third-party defaults, the external credit enhancement will fail. A cash collateral account can mitigate this concern.
Affirmative covenants set forth certain actions that borrowers must take, such as:
- Paying interest and principal on a timely basis
- Paying taxes and other claims when due
- Keeping assets in good conditions and in working order
- Submitting periodic reports to a trustee so that the trustee can evaluate the issuer's compliance with the indenture
Negative covenants set forth certain limitations and restrictions on the borrower's activities, such as:
- Limitations on the borrower's ability to incur additional debt unless certain tests are met
- Limitations on dividend payments and stock repurchases
- Limitations on the sale of assets
User Contributed Comments 9You need to log in first to add your comment.
Negative - restrictions on borrowers activities...
affirmative - actions borrowers must take....
brief and to the point
really good stuff.
This is the best study site I have ever seen.
Any financial covs?
Affirmative Action is quite easy to remember for some reason...
It is helpful and easy for memorization
@emmaskool: this site is very simple and user-friendly but in case of informativity the CFA books are still first.