Indenture refers to a legal agreement or a deed between two or more to meet its respective obligations and is a common term used in the bond market to give the lender and the borrower the required comfort in the transaction with regards to one party defaulting the other in payments or in any other way that will affect the contract as a whole.
- Earlier they were given the indentured servant status while in current times it is used as an instrument to execute debt transactions especially real estate deals.
- It comes from an English terminology named “ Indenture of RetainerRetainerA retainer is an arrangement between the firm and service provider wherein the service provider is paid an advance for services that will likely be needed in future. Retainers are commonly used in areas like law, accounting, HR.” which means it’s a legal contract prepared in duplicate in one single sheet and divided by a cutting edge and each part is handed over to the respective parties so that the same can be verified in future by reattaching the same.
- In the case of debt instruments like bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually., the indenture shows the pledge or the promises made by the issuer to the lender that he will meet all the agreed-upon covenants ( financial & non-financial) and pay the installments of the debt raised on time.
Components of Bond Indenture
Bond indentureBond IndentureBond indenture or bond resolution is a core legal document that serves as a contract binding upon the bond issuer and the bondholder. It comprises all the bond-related information, like details of the issue, its purpose, bond issuer's obligations and rights of the bondholders. will include the below-mentioned components in it :
- Purpose: It defines the purpose for which the debt has been raised by the issuer and the manner in which it will deploy in the business.
- Interest Rate: It refers to the ROI at which the debt has been raised along with the expected internal rate of return.
- Repayment Schedule: A detailed repayment schedule showing clearly the installments to be paid along with the dates and the interest bifurcation.
- Maturity Date: It refers to the date at which the debt instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans. will mature.
- Call & Put Options:Put Options:Put Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. It refers to the detailed features of the call & put options and the criteria for its fulfillment.
- Covenants: It refers to the financial & non-financial covenants that are agreed upon between the lender and borrower and the consequences of the same being breached.
Examples of Bond Indenture
Below mentioned are some of the examples of a Bond indenture agreement that both the parties have agreed upon :
In case of an NBFC, Capital Ratio is maintained to 15% and any breach below that will trigger the event.
In the above example, both the parties have agreed upon this condition to maintain the capital ratio to more than 15%. the borrower is obliged to maintain this ratio over the tenure of the loan and is expected to infuse even further capital is required if the ratio starts depleting thus giving the lender a comfort on his funds.
Bullet Payments for Debt Raised
In the above example, the borrower has signed an agreement with the lender to make the debt obligations as per the repayment schedule agreed upon. In this case, since the lender has agreed on the bullet payment for the principal component, the borrower is free to make only the interest payments at the initial stages and pay the principal amount at the tail end of the tenure.
Maintenance of Debt-Equity Ratio
In this, both the parties agree to maintain a debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. in order to curb the borrower from raising more debt from the market since there is existing debt on the books which needs to be cleared first.
Pari-Passu Clause for Assets Pledged with Lender in Case of Default
In this, the agreement may clearly state that in case of default or insolvency, there will be pari –passu charge on all the assets and the cash flows of the companyCash Flows Of The CompanyCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. and the existing lenders will be paid first as compared to other lenders on the books.
Advantages of Indenture
Below mentioned are some of the advantages of the bond indenture :
- Since it is a legal contract, all the parties involved in the transaction are liable to each other to fulfill their set of obligations as per the agreed-upon conditions.
- It gives a sense of safety and comfort to all the parties that there will be fewer chances of default and the transaction will go smoothly without any hiccups.
- It provided the authenticity to the parties since both of them have one set of the agreement since the same is cut in two pieces so that it can be verified at a later date.
- It reflects a clear understanding upon the terms and conditions of the contract so that all the parties are aware of the covenantsCovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements. and there is no conflict or misunderstanding on each one of them.
Disadvantages of Indenture
Below mentioned are some of the disadvantages of the indenture :
- There is no liberty to the parties involved in the indenture since all are restricted to play their part in the transactions and cannot deviate from the same in any manner till the maturity date of the same.
- It is non-transferable hence exit opportunities are limited in the contract due to the legality of the same.
- The contract cannot be canceled at any stage without the consent of all the parties in it.
- A minor mistake in the indenture can cost any of the parties financially which can have huge repercussions on the contract also.
- It comes with a legal cost to the company and it has to be drafted in the right manner so that neither of the parties is at risk.
Indenture is one of the most important aspects of any debit transaction to be executed, real estate in particular since the legalities involved in that are much more as compared to other sectors. It gives a lot of comfort to the lender and the borrower to have trust in the other party by inserting the right number of clauses in the contract.
This has been a guide to what is Indenture and it’s meaning. Here we discuss components and examples of indenture. Here We also discuss the advantages and disadvantages. You can learn more about accounting from following articles –