Trust Indenture (Bonds) - Explained
What is a Trust Indenture?
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What is a Trust Indenture?
A trust indenture is an agreement used during the signing of a bond contract between a bond issuer and a trustee that documents the terms and conditions governing the trustee's conduct as well as the trust beneficiaries' rights. The trust indenture represents the interests of the bondholder by underlining a set of rules and responsibilities that each entity party to the agreement is obliged to follow. A trust indenture also includes certain directives regarding the circumstances that may lead to a default and the processes that need to be followed thereupon.
How Does a Trust Indenture Work?
A government organization or a private corporation often needs to raise additional capital for various purposes. Many times, such organizations raise capital from either lenders or investors by issuing them bonds with the intermediation of a bank or a trust company that acts as a third-party trustee. This process of issue of bonds occurs under the purview of a legally-binding agreement entered into by the bond issuer and the trustee. Such an agreement is known as a trust indenture. The passage of the Trust Indenture Act (TIA) as federal law in 1939 made it mandatory for bond issues valued over $5 million to incorporate a trust indenture signed by both the bond issuer as well as the bondholder. The TIA was passed as an amendment to the Securities Act of 1933. A trust indenture includes various details such as
- The trustees personal details, such as name and contact information.
- The terms and conditions that the bond issuer, investor (or lender), and trustee are obliged to follow during the life of the bond.
- The role played by the trustee, especially with respect to handling unpredicted events.
- The various attributes of the bond, such as maturity date, face value, coupon rate, payment schedule, and reason for the bond issue.
- A clear description of the circumstances that may lead to a default and the remedial procedures that need to be followed thereupon. In fact, a trust indenture espouses a collective action mechanism that allows both creditors as well as bondholders to collect in an equitable and systematic manner in the event of a default.
A trust indenture underlines protective or restrictive covenants. This includes placing restrictions on an issuer that issues a callable bond. A callable bond is one where the issuer of the bond can pay out an early settlement of their debt by redeeming the bond before the stated maturity date. In case of callable bonds, a trust indenture has provisions to safeguard the interest of the bondholder by including a call protection. A call protection specifies a time period during which the bond issuer is restricted from repurchasing its bonds from the market. Once the period specified in the call protection passes, the bond issuer is permitted to exercise its right to call on certain call dates specified by the trust indenture. The trust indenture also specifies the call premium, i.e the price that the issuer of the bond is liable to pay to repurchase the bond. Another characteristic that is common to most trust indentures is the inclusion of subordination clauses that restrict the amount of additional debt that the issuer can incur. A subordination clause also subordinates all subsequent debts to prior debts. Such a provision is especially helpful for bondholders as it safeguards them from default risk. In case of corporate bonds with aggregate principal issues of $5 million and above, it is also mandatory to file a copy of the trust indenture with the Securities and Exchange Commission (SEC). Besides corporate bonds issues worth less than $5 million, the above rule also does not apply to municipal bonds as well as government issued bonds. The reason why entities such as municipalities and government bodies are exempted from such an obligation is that such entities usually opt for a trust indenture as a form of reassurance to prospective investors and not as a device to enforce compliance of a federal law. Moreover, it is also possible that certain government bond contracts may exclude trust indentures provided that the rights and obligations of the issuer and bondholders are clearly documented in a bond resolution.