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Default risk is affected by both the financial strength of the issuer and the terms of the bond contract, especially whether collateral has been pledged to secure the bond. Several types of contract provisions are discussed below.
Bond Indentures An indenture is a legal document that spells out the rights of both bondholders and the issuing corporation, and a trustee is an official (usually a bank) who represents the bondholders and makes sure the terms of the indenture are carried out. The indenture may be several hundred pages in length, and it will include restrictive covenants that cover such points as the conditions under which
the issuer can pay off the bonds prior to maturity, the levels at which certain of the issuer’s ratios must be maintained if the company is to issue additional debt, and restrictions against the payment of dividends unless earnings meet certain specifications.
The trustee is responsible for monitoring the covenants and for taking appropriate action if a violation does occur. What constitutes “appropriate action” varies with the circumstances. It might be that to insist on immediate compliance would result in bankruptcy and possibly large losses on the bonds. In such a case, the trustee might decide that the bondholders would be better served by giving the company a chance to
work out its problems and thus avoid forcing it into bankruptcy.
The Securities and Exchange Commission (1) approves indentures and (2) makes sure that all indenture provisions are met before allowing a company to sell new securities to the public. Also, it should be noted that the indentures of many larger corporations were actually written in the 1930s or 1940s, and that many issues of new bonds sold since then were covered by the same indenture. The interest rates on the bonds,
and perhaps also the maturities, vary depending on market conditions at the time of each issue, but bondholders’ protection as spelled out in the indenture is the same for all bonds of the same type. A firm will have different indentures for each of the major types of bonds it issues. For example, one indenture will cover its first mortgage bonds, another its debentures, and a third its convertible bonds.

Taken From : Five-Minute MBA – Corporate Finance

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