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.
Legal identity of the bond issuer and its legal form
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).
Source of repayment proceeds
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:
- Supranational organization: repayment of loans made by the organizations and contributions from members.
- Sovereign bonds: full faith and credit of the federal government (i.e. its ability to raise taxes and print money); therefore, credit risk (and yield) of local currency sovereign bonds is lowest.
- Non-sovereign government bonds: taxing authority of the issuer (such a state or local government), cash flows of the asset/infrastructure financed through the debt, general fees/taxes
- Corporate bonds: cash flows from operations of the issuer, which depends on the financial strength
- Asset-backed securities: cash flows from underlying assets such as mortgages, auto loans, etc.
Asset or collateral backing
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.
Types of collateral backing
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.