Preparing for CFA?
Practice tests, mock exams and readings with performance analytics. More Info
A trust deed (also called bond indenture) is a legal document that provides information about the issuer, defines a bond’s features (par value, coupon rate, frequency, etc.), rights of the bondholder and obligations of the issuer. It also contains information about sources of cash flows used to pay interest and principal and lists any collateral, credit enhancement, and covenants.
Collateral is an asset or financial guarantee which backs interest and principal repayment, credit enhancements are provisions aimed at reducing credit risk of a bond and covenants represent rights of the bondholder and any action which the issuer must or must not do.
A bond indenture is held by a trustee which is typically a financial institution. The trustee has a fiduciary duty towards its duties, and it carries out all administrative actions related to bond and take action on behalf of bondholders, if necessary.
A bond indenture identifies a bond’s issuer by its legal title. It is important to determine a bond’s issuer because a bond’s credit risk depends on the credit quality of the issuer. For example, if a bond is issued by a subsidiary, the credit quality of the holding company is irrelevant unless it guarantees the issue. Typically, subsidiaries have lower credit quality than the holding company, but it is not always the case, for example, where the holding company does not own any operating assets. In the case of asset-backed securities, the assets owned by the special purpose vehicle (also called special purpose entity or bankruptcy-remote entity) are relevant (and not the assets owned by the originator).
Knowing where the funds for payment or interest and repayment of principal come from is important for the underlying of a bond. The sources of funds available depend on the type of issuer:
Collateral is an asset or a guarantee which is a fallback option if the issuer defaults. It is important to understand the ranking of a bond issue and analyze the quality of collateral.
Secured bonds are bonds that are backed by an asset or a financial guarantee in event of default. Unsecured bonds have no specific backing but have a claim on general assets of the issuer. In case of unsecured bonds, the seniority ranking, the order in which different bond issues will be paid in the event of default is important. Senior debt has a preferred claim over subordinated or junior debt.
A debenture is a type of bond which may be secured or unsecured depending on the country of issue. In Commonwealth countries (such as UK, India, etc.), they are backed by a pool of assets.
There is a wide range of structures used to collateralize bond issues.
Collateral trust bonds are secured by securities such as common stock, etc.
Equipment trust certificates are backed by physical assets such as aircraft, rigs, etc. They are most used in sale and leaseback transactions to take advantage of the tax benefits of leasing, for example, through sale and leaseback transactions.
Asset-backed securities are collateralized by mortgaged property.
Covered bonds, issued by financial institutions, particularly in Europe, are backed by a cover pool, a group of assets that is held on the balance sheet of the issuer but earmarked for the bond. Covered bonds differ from asset-backed securities in that investors in covered bonds have a claim on both the cover pool and general assets of the issuer. This is why they typically have lower credit risk than an otherwise identical ABS.
Credit enhancements are provisions that improve a bond’s credit quality and decrease its yield. They are of two types: (a) internal, those which are related to the structure of the bond, and (b) external, those which are based on external third-party guarantees.
Common internal credit enhancements include subordination, over-collateralization and reserve accounts.
Subordination (also called credit tranching) is the most popular and it involves creating different tranches of a bond each with different rank. In an event of default, the senior tranches are paid before any amount can be paid to the subordinated/junior tranches. This is also called a waterfall structure.
Over-collateralization occurs when a company provides more than the required collateral. The excess collateral provides a cushion to absorb losses if any. But the valuation of collateral offers a significant challenge because asset values may drop drastically during the financial crisis.
Reserve accounts/funds have two types: cash reserve fund and excess spread account. In a cash reserve fund, cash which is meant to absorb losses in the event of default is deposited; while in the excess spread account, the excess of cash flow proceeds from assets which back the bond over the bond interest payments are deposited in an account.
Common external credit enhancements include:
Surety bonds and letters of credit have become less popular since the financial crisis. Other than the cash collateral account have some level of counterparty risk.
by Obaidullah Jan, ACA, CFA on Mon Feb 17 2020
This article can help you prepare for Reading 42 LOSb.
Loved it? Try our CFA preparation material and practice question bank!