14.4 Default risk 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.
14.5 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 level at which the issuer’s
times-interest-earned ratio must be maintained if the company is to issue
additional debt, and restrictions against the payment of dividends unless earnings
meet certain specifications.
14.6 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.
14 .7 Under a mortgage bond, the corporation pledges certain assets as security for the
bond.
14.8 The second mortgage bonds can also be secured. In the event of liquidation, the
holders of these second mortgage bonds would have a claim against the property,
but only after the first mortgage bondholders had been paid off in full. Thus,
second mortgages are sometimes called junior mortgages, because they are junior
in priority to the claims of senior mortgages or first mortgage bonds.
14.9 These indentures are generally open ended meaning that new bonds can be issued
from time to time under the existing indenture. However, the amount of new
bonds that can be issued is virtually always limited to a specified percentage of
the firm’s total “bondable property,” which generally includes all land, plan, and
equipment.
14.10 A debenture is an unsecured bond, and as such it provides no lien against
specific property as security for the obligation. Debenture holders are, therefore,
general creditors whose claims are protected by property not otherwise pledged.
In practice the value of debentures depends both on the nature of the firm’s assets
and on its general credit strength.
14.11 Subordinated Debentures: The term subordinate means “below”, or “inferior
to,” and, in the event of bankruptcy, subordinated debt has claims on assets only
after senior debt has been paid off. Subordinated debentures may be