Updated July 13, 2023
What is an Indenture?
An indenture is a legal agreement, deed, or contract between two or more parties. Historically, this type of contract was used to legally bind one person, such as an indentured servant, to work for another, as a judicial punishment, or for debt repayment.
However, the usage of the term has evolved over time. In modern-day finance, it has common usage in bond agreements, real estate deals, etc. The indenture outlines important information, e.g., interest rate, maturity date, covenants, and other terms and conditions of the credit offer.
Example of Indenture
Here are some examples to illustrate the concept in a more detailed way:
Example #1
XYZ Inc. entered into a debt agreement with ABC Bank. The agreement mentions that XYZ Inc. would maintain a debt-equity ratio of 2.0x throughout the tenure of the loan, and any breach would trigger the event. Therefore, the borrower (XYZ Inc.) and the lender (ABC Bank) 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.
Example #2
David borrowed a sum of $1,000,000 from SDF Bank to purchase 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 to make interest payments at the agreed schedule’s end. Therefore, SDF Bank agreed to the bullet payment for the principal component, while David has to make the interest payments. It will breach the agreement if he fails to repay the principal at the end of the loan tenure.
Types of Indenture
The following are the different types of indenture one may encounter in a typical business setup:
1. Real Estate Indenture
A real estate indenture is a legal document between two parties wherein both agree to continue their obligations. In this case, the first party agrees to maintain the real estate property while the other party agrees to repay the property.
2. Bankruptcy Indenture
A bankruptcy indenture refers to the proof of claim on a particular property in the event of bankruptcy. Generally, the bankruptcy indenture provides information about 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 is an underlying contract which details 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 interests of both the bondholders and the bond issuers. In a closed-end contract, the collateral used also supports the credit offer. It ensures that the collateralized property can assign to a specific credit offering, acting as collateral and provision.
Advantages of Indenture
Some of the major advantages are as follows:
- It is a binding agreement, meaning that all parties are legally obligated to fulfill each other’s commitments according to the agreed-upon conditions.
- It provides lenders with confidence that the chances of loss due to default are low and that the transaction will proceed smoothly without any significant glitches.
- Furthermore, it helps authenticate transactions between two or more parties who may not know each other well.
- It details all the terms and conditions of the agreement so that all parties with involvement are well aware of the covenants, which clearly state the borrower’s obligations and limitations.
Disadvantages of Indenture
Some of the major disadvantages are as follows:
- The terms and conditions of an indenture are strict and cannot change until the contract matures. Thus, there is no flexibility for the involved parties as all the restraints play their part in the transactions.
- There are limitations on exiting such contracts, as they are non-transferable in nature.
- All parties’ approval requires to cancel the legal agreement once it has started.
- Even a minor breach of the indenture can cause serious financial repercussions for the party on the side of error.
Key Takeaways
- In modern finance, an indenture refers to a legal agreement, deed, or contract between two or more parties that legally obliges them to honor their obligations according to the agreed-upon conditions.
- Some of the most common types of indentures are real estate, bankruptcy, and credit.
- An indenture ensures that all involved parties fulfill their commitments according to the agreed-upon conditions in the indenture.
- Breaching any of the conditions outlined in the indenture can result in significant financial consequences for the parties involved.
Conclusion
An indenture is a legally binding agreement that has evolved from historical origins to become a crucial component of modern finance. It outlines the terms and conditions of credit offerings, ensuring that all parties involved understand their obligations and limitations. All parties must consider the terms and conditions of an indenture before signing it, as it is a binding agreement that cannot be easily canceled or changed.
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