Bond Indenture and Role of Corporate Trustee
A bond indenture sets forth the obligations of the issuer. The trustee interprets the legal language of the indenture and works to make sure the issuer fulfills obligations to bondholders.
Maturity Date
The bond issuer’s obligations are fulfilled on the maturity date or before. Bonds can be retired before that date.
Interest Payment Classifications
The main types of interest payment classifications are straight-coupon bonds, zero-coupon bonds, and floating-rate bonds. Straight-coupon bonds pay a fixed cash coupon periodically. Floating-rate bonds pay a cash amount that varies with market rates. Zero-coupon bonds increase in value over the life of the issue.
There are many variations of the main types of bond structures. For example, deferred-interest bonds are a mix of zero-coupon and coupon bonds in that they do not pay cash interest in early years and pay a cash coupon in later years. Some bonds have principal in one currency and pay coupons in another currency.
Zero-coupon Bonds
Zero-coupon bonds have low reinvestment risk. The interest is based on the time-to-maturity at issuance and the original-issue discount, which is the difference between the face value and the offering price. In the case of bankruptcy, the bondholder has a claim only equal to the issue price plus accrued interest to that date, and not the full face value.
Bond Types
The holder of a mortgage bond has the first lien on real property owned by the issuer.
Collateral trust bonds are backed by stocks and bonds that represent claims against the subsidiaries of the issuer. The collateral is also called personal property.
Equipment trust certificates are a form of mortgage bond where the trustee actually owns the property and rents it to the bond issuer. The property is often in the form of standardized equipment (e.g., rail cars) that is easily sold.
Debentures are unsecured debt. Owners of debentures have a claim on the company’s assets not backing outstanding secured debt.
Methods for Retiring Bonds
Call provisions allow the firm to retire debt early at a given price. Sinking-fund provisions require the firm to buy back portions of debt each year. Call provisions are generally considered detrimental to bondholders, but sinking-fund provisions may be beneficial to bondholders.
A maintenance and replacement fund helps maintain the financial health of the firm. Cash in the fund can be used to retire debt.
Bond issuers can retire debt through a tender offer. The offer price may either be a fixed price or a price that varies with a market rate such as that on comparable Treasury securities.
Credit Risk
Credit default risk is the possibility that the issuer does not make the payments specified in the indenture. Credit spread risk is the price risk from changes in the spread of a bond’s interest rate over the corresponding Treasury rate.
Event Risk
Event risk is the possibility that a merger, restructuring, acquisition, et cetera, increases the risk of the bond by changing the ability of the firm to pay off the bonds. The indenture can try to address some of these events, but some can be omitted and lawyers can find loopholes around those included.
High-Yield Bonds
High-yield bonds can either be issued by growing, risky firms or established firms with senior debt outstanding. High-yield bonds may also be fallen angels (i.e., one-time investment grade bonds).
High-yield bonds may have coupon structures which allow the firm to conserve cash in early years, such as: (1) deferred-interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds.
Default Rate
The issuer default rate is a proportion based on the number of issues that default as a proportion of all issues. The dollar default rate estimates the dollar amount of defaulted bonds compared to the dollar amount of the corresponding population of bonds outstanding.
Recovery Rate
In the event of default, the recovery rate refers to the amount a bondholder receives as a proportion of the amount owed. Bonds with higher seniority usually have higher recovery rates.
