Indenture
The legal agreement between a bond issuer and its bondholders setting out every term of the debt — par value, coupon, maturity, collateral, seniority, options and covenants.
In plain language
When a company borrows from thousands of bondholders at once, it cannot sign a separate loan agreement with each. It signs one document that binds it to all of them. That document is the indenture.
The workbook defines an indenture as the legal agreement between two parties — in a bond indenture, the bond issuer (borrower) and the investors (lender). It provides the specific terms of the debt agreement.
Chapter 4 calls it the most important document to understand the safety aspects of the bond. Almost every question an investor should ask before buying a bond — what am I owed, when, what backs it, where do I stand if things go wrong, what can the issuer not do — is answered inside it.
How it works
What the indenture sets out (Chapter 4, section 4.3).
| Feature | What it tells the bondholder |
|---|---|
| Par value | The original value of the obligation — like the principal on a loan |
| Coupon rate and periodicity | The fixed promised percentage of face value, and how often it is paid (mostly semi-annual) |
| Maturity period | When principal is repaid (a perpetual bond has none) |
| Collateral | Whether the bond is secured against specified property |
| Seniority of payments | Where the bondholder ranks |
| Options, if any | Call, put or conversion features |
| Covenants | Rights of bondholders and restrictions on the issuer |
Covenants are of two kinds: positive covenants — actions the issuer is required to do — and negative covenants — what the issuer is prohibited from doing. They are necessary to protect the investor.
Why each issue has its own indenture (section 4.2). Unlike equity shares, a government or company can have many different bonds outstanding at the same time, each with a different maturity and coupon. These features are part of each bond's indenture, and every new issue normally carries a coupon reflecting interest rates prevailing at the time.
Secured versus unsecured. For a secured bond, the value of the asset it is secured against determines quality. An unsecured bond is backed only by the issuer's promise, so creditworthiness of the issuer determines quality — which is where credit rating agencies come in. Ratings are for an instrument, not a firm, so two bonds of the same issuer can carry different ratings.
A worked example
Illustrative issuer and terms.
A housing finance company issues two series of non-convertible debentures in the same month. Each series has its own indenture.
| Term in the indenture | Series A | Series B |
|---|---|---|
| Face value | ₹1,000 | ₹1,000 |
| Coupon | 8.40% p.a., semi-annual | 9.10% p.a., annual |
| Maturity | 3 years | 7 years |
| Collateral | Secured on a pool of loan receivables | Unsecured |
| Seniority | Senior | Subordinated |
| Option | None | Issuer call option after year 5 |
| Covenant example | Issuer must maintain the security cover (positive) | Issuer may not create a prior charge on specified assets (negative) |
Ravi, a fixed income investor, is offered both. The indenture shows him why Series B pays more: it is unsecured, subordinated, longer, and callable — so it carries more credit risk and a reinvestment risk if called when rates fall.
A coupon of ₹84 a year on each Series A debenture (8.40% × ₹1,000) paid semi-annually means ₹42 every six months. That, too, comes straight from the indenture.
Why NISM asks about it
Indenture is defined in Chapter 4 (Investing in Fixed Income Securities), first in a footnote to section 4.2 and then in section 4.3 on the determinants of bond safety, where it is described as the most important document for understanding a bond's safety. Covenants, collateral, seniority, embedded options and credit ratings all sit inside that discussion. For a PMS distributor, fixed income PMS portfolios are built from bonds whose terms live in indentures.
Common exam traps
- The indenture is between issuer and bondholders, not between the issuer and a rating agency or exchange.
- Covenants are part of the indenture, not a separate agreement.
- Positive covenants = must do; negative covenants = must not do.
- Each bond issue has its own terms — one company, many indentures.
- Secured bond quality depends on the collateral's value; unsecured bond quality on the issuer's creditworthiness.
- Ratings attach to the instrument, so two bonds of one issuer can differ.
Check yourself
1.A bond indenture contains a clause that prohibits the issuer from selling the plant pledged as collateral for the bond. Such a clause is:
- a)A negative covenant
- b)A positive covenant
- c)A put provision
- d)A call provision
Show the answer
Answer: (a) A negative covenant
Covenants are “clauses specifying the rights of the bond holders and restrictions on the bond issuers”. “Positive covenants are actions which issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing.” A ban on selling the pledged plant is a prohibition, so it is a negative covenant.
A put provision gives bondholders the right to sell the bond back to the issuer at a pre-determined price. A call provision gives the issuer the right to redeem the bonds before maturity. Both are embedded options, not covenants.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- Credit ratingAn opinion on how likely a borrower is to service an instrument on time, reduced to a symbol by a SEBI-registered rating agency — and reviewed continuously, not fixed for the life of the bond.
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Face valueThe denomination a company's capital is divided into and carried in its books — fixed, printed on the certificate, and the base on which dividend percentages and stock splits are computed.
- Callable bondA bond that the issuer may redeem before its original maturity date — typically exercised when interest rates fall, leaving the investor to reinvest at lower rates.
- Fixed income securityA debt instrument under which the issuer promises a fixed coupon at regular intervals and repayment of the face value at maturity — government bonds, corporate bonds, debentures and T-bills.
- Perpetual bondA bond with no maturity date at all — it keeps paying coupons unless called, so it is valued as the present value of an endless coupon stream rather than as a bond that returns principal on a fixed date.
- CovenantsClauses in a bond's indenture specifying the rights of bondholders and restrictions on the issuer. Positive covenants say what the issuer must do; negative covenants say what it must not do.
- DebentureIn Indian usage, a long-term debt instrument issued by a company, bank or financial institution — as opposed to a bond, the term reserved for debt issued by a government or its undertakings.