What is an Indenture?
The term “indenture” refers to the legal agreement, deed, or contract signed between two or more parties. In the past, this type of contract was used to legally bind one person (indentured servant) to work for another either in the form of judicial punishment, debt repayment, etc. Over the period, the usage of the term has evolved, and in modern-day finance, it is commonly found in bond agreements, real estate deals, etc. wherein it details various key information such as rate of interest, maturity date, covenants, along with other terms and conditions of the credit offer.
Example of Indenture
Now, let us look at some of the examples to illustrate the concept in more detail.
XYZ Inc. entered into a debt agreement with ABC Bank wherein it is mentioned that XYZ Inc. will maintain a debt-equity ratio of 2.0x throughout the tenure of the loan, and any breach will trigger the event. So, the borrower (XYZ Inc.) and the lender (ABC Bank) have agreed upon this condition of maintaining the debt-equity ratio above 2.0x. XYZ Inc. is obliged to maintain the ratio throughout the loan tenure and is expected to infuse more equity capital if the ratio falls below the threshold figure of 2.0x.
David borrowed a sum of $1,000,000 from SDF Bank for purchasing a new real estate property. He signed the debt agreement with the lender to make the principal repayment at the end of five years and make the interest payment at the agreed schedule’s end. So, SDF Bank has agreed on the bullet payment for the principal component, while David has to make the interest payments. If he fails to repay the principal at the end of the loan tenure, it will breach the agreement.
Types of Indenture
Now, let us look at the different types that we may encounter in a typical business setup.
1. Real Estate Indenture
A real estate indenture refers to a deed between two parties wherein the involved parties agree to continue the obligations. In this case, the first party agrees to maintain the real estate property while the other party agrees to make the repayments for the property.
2. Bankruptcy Indenture
A bankruptcy indenture simply refers to the proof of claim on a particular property. Generally, the bankruptcy indenture provides information pertaining to the collateralized property and, in the process, constitutes the lender’s claim against the borrower, which is secured by the lien on the property.
3. Credit Indenture
A credit indenture refers to the underlying contract which captures details about all the clauses and provisions linked to a particular credit offering. In the case of unsecured bond offerings, this type of indenture is known as a debenture. It usually safeguards the interest of both the bondholders and the bond issuers. In a closed-end indenture, the collateral used also provides backing for the credit offer, which means it acts as collateral as well as provision, ensuring that the collateralized property can be assigned to a particular credit offering.
Advantages of Indenture
Some of the major advantages are as follows:
- It is a binding agreement, which means that all the involved parties are legally obliged to fulfil each other’s commitments as per the agreed conditions.
- It provides confidence to the lender that the chances of loss due to default are very low, and the transaction will take place smoothly without any major glitches.
- It helps in authenticating the transaction between two or more parties that probably don’t know each other that well.
- It details all the terms and conditions of the agreement such that the involved parties are well aware of the covenants, which clearly state the borrower’s obligations as well as limitations.
Disadvantages of Indenture
Some of the major disadvantages are as follows:
- The terms and conditions of an indenture are strict and can’t be changed until the maturity of the contract. Hence, there is no flexibility for the involved parties as all the restraints play their part in the transactions.
- There is a limited scope of exiting such contracts as these are non-transferable in nature.
- The legal agreement, once started, can’t be cancelled without the approval of all the involved parties.
- Even a small breach of the indenture can result in serious financial repercussions for the party on the wrong side of the action.
Some of the key takeaways of the article are:
- In modern-day finance, an indenture refers to the legal agreement, deed, or contract between two or more parties that legally obliges the involved parties to honour their obligations as per the agreed conditions.
- Typically, an indenture provides various details about the credit offering, such as interest rate, maturity date, covenants, and other terms and conditions.
- Some of the most common types of indentures include real estate indenture, bankruptcy indenture, and credit indenture.
- It ensures that all the involved parties fulfil their commitments as per the agreed conditions in the indenture.
- Breach of any of the conditions captured in the indenture can result in huge financial ramifications for the involved parties.
So, it can be seen that indenture is a very important part of any financial transaction. It helps in managing the covenants and the associated legalities of a transaction. It helps in safeguarding the interests of both the lender and the borrower.
This is a guide to Indenture. Here we also discuss the definition, examples, and types of Indenture along with advantages and disadvantages. You may also have a look at the following articles to learn more –