Standard Provisions The standard debt provisionsin the bond indenture
specify certain record-keeping and general business practices that the bond issuer
must follow. Standard debt provisions do not normally place a burden on a
financially sound business.
The borrower commonly must (1) maintain satisfactory accounting records
in accordance with generally accepted accounting principles (GAAP); (2) periodi-
cally supply audited financial statements; (3) pay taxes and other liabilities when
due;and (4) maintain all facilities in good working order.Restrictive Provisions Bond indentures also normally include certain
restrictive covenants,which place operating and financial constraints on the
borrower. These provisions help protect the bondholder against increases in bor-
rower risk. Without them, the borrower could increase the firm’s risk but not
have to pay increased interest to compensate for the increased risk.
The most common restrictive covenants do the following:- Require a minimum level of liquidity,to ensure against loan default.
- Prohibit the sale of accounts receivableto generate cash. Selling receivables
could cause a long-run cash shortage if proceeds were used to meet current
obligations. - Impose fixed-asset restrictions.The borrower must maintain a specified level
of fixed assets to guarantee its ability to repay the bonds. - Constrain subsequent borrowing.Additional long-term debt may be prohib-
ited, or additional borrowing may be subordinatedto the original loan.
Subordinationmeans that subsequent creditors agree to wait until all claims
of the senior debtare satisfied. - Limit the firm’s annual cash dividend paymentsto a specified percentage or
amount.
Other restrictive covenants are sometimes included in bond indentures.The violation of any standard or restrictive provision by the borrower gives
the bondholders the right to demand immediate repayment of the debt. Gener-
ally, bondholders evaluate any violation to determine whether it jeopardizes the
loan. They may then decide to demand immediate repayment, continue the loan,
or alter the terms of the bond indenture.Sinking-Fund Requirements Another common restrictive provision is a
sinking-fund requirement.Its objective is to provide for the systematic retirement
of bonds prior to their maturity. To carry out this requirement, the corporation
makes semiannual or annual payments that are used to retire bonds by purchas-
ing them in the marketplace.Security Interest The bond indenture identifies any collateral pledged
against the bond and specifies how it is to be maintained. The protection of bond
collateral is crucial to guarantee the safety of a bond issue.274 PART 2 Important Financial Concepts
restrictive covenants
Provisions in a bond indenture
that place operating and
financial constraints on the
borrower.
subordination
In a bond indenture, the stipula-
tion that subsequent creditors
agree to wait until all claims of
the senior debtare satisfied.
sinking-fund requirement
A restrictive provision often
included in a bond indenture,
providing for the systematic
retirement of bonds prior to their
maturity.
standard debt provisions
Provisions in a bond indenture
specifying certain record-
keeping and general business
practices that the bond issuer
must follow; normally, they do
not place a burden on a
financially sound business.