Bond Indenture Review Guide

What it is

A bond indenture is the contract that governs the rights and obligations between the issuer of a bond, the trustee (acting on behalf of bondholders), and indirectly the bondholders themselves. The Trust Indenture Act of 1939 governs many qualified indentures in the U.S.; high-yield indentures follow a heavily-templated format developed over decades.

Indentures are long (often 200+ pages), but the legal substance is concentrated in two sections: the financial covenants (typically Article 4) and events of default (typically Article 6). Most other provisions are mechanical — payment, transfer, registration, the trustee's role.

Bondholder protections in indentures vary by issuer credit quality. Investment-grade indentures are light on covenants; high-yield (junk) indentures are heavy. Distressed-debt investors learn to read indentures forensically, looking for covenant gaps that allow asset transfers, debt issuance, or other moves that affect bondholder recoveries.

Common clauses to check

1. [ 01 ]

   Restricted Payments

   Limits on dividends, share buybacks, and other distributions to equity holders. The classic high-yield bondholder protection.

   What to look for

   • Builder basket (allowable RP capacity that grows with retained net income).
   • General basket (fixed dollar amount).
   • Carve-outs — permitted distributions with no restriction (taxes, indemnification).
   • RP triggers tied to leverage ratios (no RP if leverage exceeds X).

   Red flags

   • Wide builder basket without leverage tests.
   • Multiple overlapping baskets that combine to permit large distributions.
   • Carve-outs that swallow the restriction.
   • Pre-approved "permitted investments" that act as backdoor RPs.
2. [ 02 ]

   Debt Incurrence

   Limits on issuing additional debt that would compete with the existing bonds for repayment.

   What to look for

   • Pro forma leverage incurrence test.
   • Permitted debt baskets — capital leases, hedging, refinancing existing debt.
   • Senior debt incurrence baskets.
   • Subsidiary guarantee requirements on incremental debt.

   Red flags

   • Wide general baskets ("$100M of additional debt" without leverage test).
   • Refinancing baskets that allow upsizing.
   • Permitted debt at subsidiaries that bypass parent-level covenants.
3. [ 03 ]

   Liens

   Restrictions on granting security interests that would prime existing bondholders.

   What to look for

   • List of permitted liens (purchase money, capital leases, mechanic's liens).
   • General lien basket size.
   • Equal-and-ratable lien provisions for incremental secured debt.

   Red flags

   • Wide general lien basket allowing secured debt issuance ahead of bonds.
   • Permitted liens at subsidiaries that don't flow up to parent.
   • No equal-and-ratable provision.
4. [ 04 ]

   Asset Sales

   Limits on selling assets and use of proceeds. Critical for credit because asset sales reduce the collateral pool.

   What to look for

   • Fair value test (asset sales for fair value).
   • Use of proceeds — reinvestment in business or repay debt.
   • Asset-sale offer to bondholders if proceeds not reinvested.
   • Scope — does it apply to all asset sales or only "sales of substantial assets"?

   Red flags

   • Reinvestment rights without a maximum reinvestment window.
   • No bondholder offer if proceeds are diverted.
   • Asset-sale exclusion for "ordinary course" sales defined too broadly.
5. [ 05 ]

   Change of Control

   Investor protection on sale or merger. Typically requires the issuer to offer to repurchase bonds at a premium (101% is standard).

   What to look for

   • Definition of Change of Control — including thresholds (50% of voting power) and mergers.
   • Repurchase offer at 101% of principal plus accrued interest.
   • Carve-outs for permitted holders (founders, sponsor).
   • Timing — typically 30 days from triggering event.

   Red flags

   • Narrow Change of Control definition that doesn't capture sale to permitted holder consolidation.
   • Repurchase below 101%.
   • Requirement for Change of Control to be "unsolicited" to trigger repurchase.
6. [ 06 ]

   Restricted vs. Unrestricted Subsidiaries

   Issuer can designate subsidiaries as Unrestricted, removing them from covenant compliance. Famously exploited in J.Crew, PetSmart, and other transactions.

   What to look for

   • Mechanism to designate a subsidiary as Unrestricted.
   • Restrictions on assets transferable to Unrestricted subs.
   • Permitted investment baskets that flow to Unrestricted subs.
   • Covenant flow-down to Restricted subs.

   Red flags

   • Wide latitude to designate subsidiaries as Unrestricted with valuable assets.
   • Permitted investment baskets large enough to transfer significant value to Unrestricted subs.
   • No fairness test on transfers to Unrestricted subs.
7. [ 07 ]

   Events of Default & Acceleration

   What gives bondholders the right to accelerate principal and interest.

   What to look for

   • Failure to pay (with grace periods).
   • Breach of covenants with cure periods (60-90 days for non-payment defaults).
   • Cross-default and cross-acceleration.
   • Bankruptcy.
   • Holders' threshold to accelerate — typically 25% of outstanding principal.

   Red flags

   • Cross-default thresholds set very low.
   • Long cure periods that allow issuer to game compliance.
   • High holder threshold to accelerate (over 25%) that prevents bondholder action.
8. [ 08 ]

   Covenant Defeasance

   Issuer's right to deposit cash or government securities sufficient to pay all bond obligations and thereby be released from indenture covenants.

   What to look for

   • Defeasance mechanics (cash or government securities held by trustee).
   • Tax opinion required (for legal defeasance).
   • Whether defeasance applies to all covenants or only certain ones.

   Red flags

   • Easy defeasance with minimal opinions or holdbacks.
   • Defeasance that releases issuer from change-of-control put obligations.

Other watchouts

• Trustee's duties under Trust Indenture Act.
• Successor obligor provisions.
• Amendment thresholds (50% / 75% / 100% holder consent).
• Voting rules — by class, subclass, all bondholders.
• Make-whole provisions for early redemption.
• Equity Clawback provisions allowing partial redemption from IPO proceeds.
• Short-term notes vs. long bonds — different conventions.
• Successor and assigns provisions.
• Reporting requirements (10-K, 10-Q, special events).
• Listing requirements on exchanges where bonds trade.

Frequently asked questions

What's a bond indenture?

The contract governing a bond issue. The parties are the issuer and the trustee (acting on behalf of bondholders); bondholders themselves don't sign individually but get the benefits and obligations as third-party beneficiaries. Indentures cover payment terms, covenants, events of default, and remedies.

What's a Restricted Payments covenant?

A covenant limiting the issuer's ability to make distributions to equity holders — dividends, share buybacks, junior debt repurchases. Standard high-yield bondholder protection. Includes a "builder basket" that grows with retained earnings, plus general baskets and various carve-outs.

What is the difference between Restricted and Unrestricted Subsidiaries?

Restricted Subsidiaries are subject to the indenture's covenants and considered "on credit" with the parent. Unrestricted Subsidiaries are designated outside the covenant structure — their actions don't count for covenants, and their assets aren't generally available to bondholders. Famous transactions (J.Crew, Revlon, Travelport) have used Unrestricted Subsidiary designations to transfer collateral.

What is a Change of Control put?

Bondholders' right to require the issuer to repurchase the bonds at a premium (typically 101%) if a change of control occurs. Standard provision; differences are in the definition of Change of Control (carve-outs for sponsor takeovers, etc.).

What is covenant defeasance?

A mechanism by which the issuer can be released from indenture covenants by depositing sufficient cash and government securities with the trustee to pay all obligations on the bonds. Allows the issuer to refinance or restructure without renegotiating each covenant. Two flavors: legal defeasance (full release) and covenant defeasance (release from most covenants but not certain provisions).