115 CFA
File: Fixed Income - Reading 42 - 2. Bond Indenture

2. Bond Indenture

b. describe content of a bond indenture;

c. compare affirmative and negative covenants and identify examples of each;

What is a bond indenture?
An indenture is the contract between the issuer and the bondholder specifying the issuer's legal requirements. It contains the promises of the issuer and the rights of the holder of the bond.

What role does a trustee play in the issuance of a bond?
Bonds are indentured to the name of a trustee, not the bondholder, because the trustee acts as fiduciary on behalf of the bondholder to ascertain whether the issuer is fulfilling its obligations.

What forms of legal entity can issue a bond?
- The primary legal entity
- A subsidiary of the legal entity
- A holding company
- A special-purpose vehicle/entity (a separate legal entity) can issue bonds collateralized by assets transferred from its sponsor

What is bankruptcy remote?
If bankruptcy occurs in a situation where a parent entity sponsors assets into an SPV in order for the SPV to issue bonds, the sponsor's creditors cannot go after such assets; this is known as bankruptcy remote.

What are covered bonds?
Covered bonds are debts issued by banks that are fully collateralized by residential or commercial mortgage loans or by loans to public sector institutions.

How does bond trance structure reduce bond credit risk?
The senior tranches get paid first, and the subordinated tranches get paid only if there are enough funds left. The subordinated tranches absorb the credit risk, making the senior tranches less risky.

How does Overcollateralization reduce bond credit risk?
The amount of overcollateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral's value is $105 million, then the first $5 million loss will not result in a loss to any of the tranches.

How does excess spread reduce bond credit risk?
Underlying assets support a higher level of payment than that promised to security holders.

What are affirmative vs negative bond covenants?
- Affirmative covenants set forth certain actions that borrowers must take
- Negative covenants set forth certain limitations and restrictions on the borrower's activities

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