The Indenture

The indenture is the written agreement between the corporation (the borrower) and its creditors. It is sometimes referred to as the deed of trust} Usually, a trustee (a bank, perhaps) is appointed by the corporation to represent the bondholders. The trust company must (1) make sure the terms of the indenture are obeyed, (2) manage the sinking fund (described in the following pages), and (3) represent the bondholders in default, that is, if the company defaults on its payments to them.

The bond indenture is a legal document. It can run several hundred pages and generally makes for very tedious reading. It is an important document, however, because it generally includes the following provisions:

1. The basic terms of the bonds

2. The total amount of bonds issued

3. A description of property used as security

4. The repayment arrangements

5. The call provisions

6. Details of the protective covenants

We discuss these features next.

indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue.

3The words loan agreement or loan contract are usually used for privately placed debt and term loans.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

PART THREE Valuation of Future Cash Flows registered form

The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record.

Terms of a Bond Corporate bonds usually have a face value (that is, a denomination) of $1,000. This is called the principal value and it is stated on the bond certificate. So, if a corporation wanted to borrow $1 million, 1,000 bonds would have to be sold. The par value (that is, initial accounting value) of a bond is almost always the same as the face value, and the terms are used interchangeably in practice.

Corporate bonds are usually in registered form. For example, the indenture might read as follows:

Interest is payable semiannually on July 1 and January 1 of each year to the person in whose name the bond is registered at the close of business on June 15 or December 15, respectively.

bearer form

The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whoever holds the bond.

www.e-analytics.com has . more bond information.

www.e-analytics.com has . more bond information.

debenture

An unsecured debt, usually with a maturity of 10 years or more.

note

An unsecured debt, usually with a maturity under 10 years.

This means that the company has a registrar who will record the ownership of each bond and record any changes in ownership. The company will pay the interest and principal by check mailed directly to the address of the owner of record. A corporate bond may be registered and have attached "coupons." To obtain an interest payment, the owner must separate a coupon from the bond certificate and send it to the company registrar (the paying agent).

Alternatively, the bond could be in bearer form. This means that the certificate is the basic evidence of ownership, and the corporation will "pay the bearer." Ownership is not otherwise recorded, and, as with a registered bond with attached coupons, the holder of the bond certificate detaches the coupons and sends them to the company to receive payment.

There are two drawbacks to bearer bonds. First, they are difficult to recover if they are lost or stolen. Second, because the company does not know who owns its bonds, it cannot notify bondholders of important events. Bearer bonds were once the dominant type, but they are now much less common (in the United States) than registered bonds.

Security Debt securities are classified according to the collateral and mortgages used to protect the bondholder.

Collateral is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt. For example, collateral trust bonds often involve a pledge of common stock held by the corporation. However, the term collateral is commonly used to refer to any asset pledged on a debt.

Mortgage securities are secured by a mortgage on the real property of the borrower. The property involved is usually real estate, for example, land or buildings. The legal document that describes the mortgage is called a mortgage trust indenture or trust deed.

Sometimes mortgages are on specific property, for example, a railroad car. More often, blanket mortgages are used. A blanket mortgage pledges all the real property owned by the company.4

Bonds frequently represent unsecured obligations of the company. A debenture is an unsecured bond, for which no specific pledge of property is made. The May Department Stores bond examined in the table is an example. The term note is generally used for such instruments if the maturity of the unsecured bond is less than 10 or so years when the bond is originally issued. Debenture holders only have a claim on property not otherwise pledged, in other words, the property that remains after mortgages and collateral trusts are taken into account.

4Real property includes land and things "affixed thereto." It does not include cash or inventories.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

CHAPTER 7 Interest Rates and Bond Valuation

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