What Is a Trust Indenture?
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.
key takeaways
- A trust indenture is legal and binding bond contract made between a bond issuer and a trustee to protect the bondholder’s interests.
- A trust indenture describes the bond’s characteristics and the terms of its callability. It also delineates the amount of additional debt the issuer can assume, and the circumstances and procedures in case of issuer default.
- Most corporate bond issues over $5 million are required to include a trust indenture, and to file a copy of it with the SEC.
How a Trust Indenture Works
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 trusteeusually a bank or trust company, to represent investors who buy the bond. 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 fiduciaryin 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 ratepayment 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 by the issuer takes place. A bondholder should be aware of and understand the proper sequence of events, allowing them to take the proper course of action should such a situation occur.
Special Provisions of a Trust Indenture
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 that dictate that all subsequent debts are subordinated to prior debts. Without such restrictions, an issuer would theroretically be allowed to issue an unlimited amount of debt, increasing bondholders’ exposure to default risk.
Which Bonds Have Trust Indentures?
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.
Many of the current rules regarding trust indentures were established by the Trust Indenture Act (TIA), a piece of legislation passed in 1939 to protect bondholders and investors.
However, most corporate offerings must include a trust indenture. A copy of it 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. Of course, these exempted entities may choose to create a trust indenture to reassure prospective bond buyers, if not to adhere to any federal law.