Indenture

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.

An indenture contract 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 than other sectors. It gives the lender and the borrower a lot of comforts to trust the other party by inserting the right number of clauses in the contract.

1. It is a phrase frequently used in the bond market to provide the lender and the borrower with the necessary assurance in the transaction regarding one party's default on payments to the other.
2. Indenture includes call & put options, purpose, interest rates, covenants, and repayment schedule.
3. Indentures are beneficial since it is a legal contracts. Therefore, all parties involved in the transaction are obligated to carry out their respective obligations by the terms of the agreement.
4. They have cons because the contract's departure options are constrained because they cannot be transferred.

Indenture is a term that comes from an English terminology named “ Indenture of Retainer” 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.

Earlier, the defaulters in a deal were given the indentured servant status while in current times it is used as an instrument to execute debt transactions especially real estate deals.

In the case of debt instruments like bonds, 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.

A bond indenture 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 instrument will mature.
• Call & Put Options: It refers to the detailed features of the call & put options and the criteria for its fulfillment.
• Covenants: These refer to the financial & non-financial covenants that are agreed upon between the lender and borrower and the consequences of the same being breached.

To let us understand what is an indenture, it is important to checkout some examples. Below mentioned are some examples of a Bond indenture agreement that both parties have agreed upon :

Example #1

In the case of an NBFC, Capital Ratio is maintained at 15% and any breach below that will trigger the event.

In the above example, both 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 comfort on his funds.

Example #2

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.

Example #3

Maintenance of Debt-Equity Ratio

In this, both the parties agree to maintain a debt-equity ratio 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.

Example #4

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 company and the existing lenders will be paid first as compared to other lenders on the books.

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 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 of the terms and conditions of the contract so that all the parties are aware of the covenants and there is no conflict or misunderstanding on each one of them.

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 playing 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.

This has been a guide to Indenture is & its meaning. Here we explain its examples, components, advantages, and disadvantages. You can learn more about accounting from the following articles –

• Bond Indenture Meaning
• Premium Bonds
• Corporate Bonds Types
• What is Surety Bond?