Indenture

What Is an Indenture?

An indenture is the formal legal contract that governs a bond issue. It is signed by the issuer, which may be a corporation or a government body, and by a trustee, a financial institution that acts on behalf of all bondholders. The indenture spells out the rights and obligations of each party, so every holder of bonds in the same issue is bound by the same terms. The name comes from an old practice of writing two copies of an agreement on one sheet and cutting them apart along a jagged, or indented, line.

What an Indenture Contains

Indentures are long, detailed documents, but most cover a similar set of topics:

• The total amount being borrowed and the coupon rate paid to holders
• The payment schedule and the maturity date, when principal is repaid
• Whether the bonds are secured by specific assets or are unsecured
• Restrictions on the issuer, known as covenants, such as limits on taking on more debt or selling key assets
• What counts as an event of default and what remedies the trustee and bondholders can pursue
• Whether the issuer can redeem the bonds early, and on what terms
• How the trustee's duties are defined and how bondholders can vote to amend the agreement

Why Indentures Matter to Investors

Because the indenture is the binding document, it largely determines how much protection a bondholder has. Clear terms on default, collateral, and restrictions generally give holders more ability to act if the issuer runs into trouble. Changes to an indenture usually require approval from a share of bondholders defined in the document itself, so the terms are not easily altered.

In the United States, the Trust Indenture Act of 1939 regulates indentures for bonds sold to the public. It requires that the trustee be independent of the issuer and sets standards the indenture must meet before the bonds are offered. Many privately placed bonds fall outside the act, so their terms are set entirely by negotiation between the parties.