The Life of a Corporate Bond

A Legal Perspective on the Bond Lifecycle

The Legal Lens

Corporate bonds are one of the most widely discussed and traded financial instruments. While many are quick to do the mathematics to calculate returns or make the most efficient trade, not many focus on the legalities that go into the preservation of this pivotal capital markets tool. Therefore, this article examines the role of the law along different stages of a bond, that is the lifecycle of a corporate bond through a legal lens.

Birth — Issuance and the Indenture

Before examining the birth of a corporate bond, it is necessary to understand the purpose of a bond. When financing for major business decisions, large amounts of funds are required. When such large sums of money are acquired through traditional lending means, for example, bank loans, the banks are likely to impose too many restrictions on the company in addition to harsh interest rates and collateral requirements. To avoid such stifling terms, companies issue large numbers of bonds with each bond having a much smaller face value. For example, when a company requires $10 billion, they might issue ten million bonds, each with a face value of $1,000. In this way, the company gains multiple investors of varying financial capital while preventing stagnation of capital.

However, such a system still needs to be supervised. This is where a legal agreement called an indenture plays a role. The indenture functions almost like a constitution of the bond, and lays out details such as coupon rates, maturity periods, restrictions imposed upon the issuer, and actions to be undertaken in the case of default. It also explains the relationships between the parties involved in great detail. These include the issuer, the bondholders and the corporate trustee. The corporate trustee acts on behalf of all the bondholders in a fiduciary capacity, and is usually a large bank or a trust company. The trustee ensures that the issuer acts promptly and complies with the financial restrictions, i.e., covenants set out in the indenture. However, the main purpose of the trustee is to avoid chaotic legal consequences in the event of a breach of the indenture. In its absence there would likely be thousands of lawsuits, as each individual investor would seek separate legal action. Instead, the trustee can act in accordance with the indenture and take necessary legal action to protect bondholders’ rights.

Therefore, the moment bonds are issued, a legal relationship is created by the indenture. The issuer gains cash from the investors and is expected to pay coupons on schedule, repay principal at maturity, comply with covenants and not breach any other terms of the indenture. Similarly, the bondholders retain the rights to receive coupon and principal payments along with legal protection from the indenture. While many focus on the coupon rates and yield measures of the bond, the indenture is what transforms the bond into a tangible, enforceable financial instrument rather than a collection of promises.

Life — Covenants and Supervision

Now that the bond has been issued, and the indenture’s rules have been set, how can the trustee ensure that the issuer keeps their long-term promises? This is where the concept of bond covenants becomes crucial. These are a set of legally binding agreements to avoid irresponsible management of funds until the bonds remain outstanding. They impose financial restrictions on the issuer in the indenture to minimise credit and event risk for the bondholders before default occurs. While some of these covenants prevent the issuer from doing something irresponsible such as excessive borrowing, asset sales or dividend payments, the others impose certain compulsory actions on the issuer such as regular coupon payments, maintaining audited financial statements and accounting records and asset insurance. The former is referred to as a negative covenant while the latter is called an affirmative covenant. Covenants protect bondholders’ investments through a preventive system by addressing problems before defaults.

As covenants exist to identify issues before defaults, a covenant breach is not registered as a default, but is only used initially to notify the issuer. For example, failing to maintain a certain financial ratio may breach a covenant. When identified, the issuer is informed of this and is given a “grace period” or an opportunity to cure the breach by the indenture. If the breach is corrected, the bond continues as planned. This is not the same as an event of default breach, which will be dealt with in the next part.

However, this hints at an apparent contradiction: why do issuers accept covenants when they cause the same immobilisation of capital as bank loans? They accept these terms because much like the banks, investors demand security, which in the absence of covenants, could only be sought out by higher interest rates. Therefore, to minimise debt servicing costs, issuers accept covenants.

The central lesson of covenants is that ongoing monitoring is much better than suing after default. This is because the issuer may have sold a number of important assets or changed creditor priorities over the years which would lead to large losses for the investors. In contrast, ongoing monitoring allows for gradual checks of financial responsibility. This system reflects the principle that prevention is preferable to remedy. Despite this, not all issuers remain financially healthy. When contractual protections fail, the legal relationship enters its most demanding phase.

Stress — Credit Spreads, Breaches and Negotiations

This is the most complex stage of the life cycle of a corporate bond. While the previous phase dealt with how default is prevented, this phase explains what happens when the issuer experiences financial instability, generally marked by bond price changes and covenant breaches. The most important concept in this phase is credit risk, and how it is dynamic instead of static. As the bond remains outstanding for multiple years, the issuer’s performance is likely to fluctuate. Consequently, any such changes are likely to affect the issuer’s ability to pay back the bonds. Therefore, credit risk is never constant.

This change in credit risk is not noticed through explicit covenant breaches in the beginning. The market registers this earlier. If the market’s perception of the issuer’s credit safety reduces over time due to changes in performance, the price of bonds will automatically fall. This is because investors are always seeking higher returns. Since perceived credit risk increases, investors would only buy the bond if a higher return is ensured. While this can be done by increasing coupon rates, coupon rates are fixed. Therefore, the price of the bond falls relative to the face value. This results in a higher current yield as the coupon payment is a higher percentage of the bond price. This widens the credit spread, which is the difference between the risk-free return (for example, treasury yields) and the current yield. However, this is just the story for investors who do not mind the risk.

For those investors who do not want this risk, there is a particularly useful financial instrument, Credit Default Swaps (CDS). This functions much like insurance. If a large investor, who owns bonds of the distressed issuer in large amounts, potentially amounting to hundreds of millions, wants to transfer this risk, they buy CDS protection. This investor would go to the CDS provider and pay a yearly premium so that they would be compensated by the provider in the case of a default. As is the case with most swaps (a class of financial derivatives), the asset (the bonds) does not change hands, only the risk moves.

Now that the initial change in credit risk has happened, and the market has reacted, covenant breaches begin to surface, and legal involvement increases. When a company is in such distress, it is inevitable that some important financial ratios reach less ideal values. These ratios are under immense scrutiny as the covenants regularly reference them. This is why covenant breaches are only a matter of time for a distressed company. Breaches set off the alarm that the issuer’s condition has deteriorated, and the trustee steps in to prevent default. As mentioned in the previous phase, at this stage, defaults are actively avoided, and covenant negotiations are set up to prevent them. This is done through opportunities to cure the breach. These involve waivers and amendments. Waivers overlook breaches altogether, while amendments are changes to indenture specifics to be more flexible and continue the bond. Occasionally, these negotiations also involve broader processes like increasing coupon rates or increasing collateral provision. At this point, the bond’s future depends on the success of the negotiations. Success leads to an orderly conclusion, i.e., the law facilitates repayment, while failure leads to an Event of Default, where the law protects rights through contractual enforcement.

When Negotiations Succeed

In this case, after all the problems faced in the previous phase, normal bond maturity is still achieved through a cumulative effort from both the bondholders and issuers. These include the previously mentioned waivers, amendments, “grace periods” from the former party, while the latter improves financial health by reducing dividend payments, selling non-core assets, restructuring debt, etc. At maturity, the final coupon along with principal, is paid. Even though the company almost collapsed, the contractual relationship survived. This is called a “stressed maturity”.

When Negotiations Fail

An Event of Default occurs. This refers to a serious contractual failure specified in the indenture, which gives the trustee the power to enact harsh remedies on behalf of the bondholders. The most common remedy is acceleration, which is an indenture-approved declaration by the trustee before the maturity period to accelerate payment of the principal. This pushes the maturity period ahead even if only coupons are due at the time. During this phase, the trustee no longer monitors, it enforces.

The enforcement could occur in a number of ways. These include payment demands, security demands (some bonds are secured by capital, and these could be demanded at this stage) or even the commencement of litigation proceedings.

Despite all this, what happens if acceleration fails, and the company is unable to pay? The first option is restructuring. This is a collaborative attempt to restructure the terms of the bond. The principal and coupon payments are lowered to give the company short-term relief. Yet, why would the bondholders be more patient while receiving less than the predetermined amount? This is because a living business is still more valuable than a dead one, as immediate liquidation of the company would only yield lower returns.

The second option is insolvency or bankruptcy. This is where contract law diminishes and insolvency law takes over. In this case, all the assets of the company are calculated and liquidated. All this is then paid to stakeholders (secured creditors, unsecured creditors and shareholders) with a system of prioritisation kept in mind (the capital structure). While those at the top levels of this capital structure are ensured some of their funds back, those on the lower end often receive negligible amounts or in some cases, none of their funds back.

Maturity — The Investment-Grade Path

Now, all the phases we have explored, show us the life of a bond. However in this exploration, we have assumed that a number of problems arise and many things work out not optimally. We have discussed the exception which is generally what happens with less than investment-grade bonds. Many successful companies have issued bonds in the past, continue to do so, and still remain profitable. These are reliable companies who issue investment-grade bonds, that is coupons were paid regularly, no covenants were breached, no legal actions and no negotiations. In this case, the bond reaches maturity as expected, and the contractual obligations of the issuer end. Along with this, the trustee’s role ends and bondholders are compensated.

Alternative Methods of Resolution

Sometimes, companies do not want to wait until maturity. This happens when interest rates fall considerably, and the coupon payments become unnecessarily expensive. The company then decides to redeem the bonds earlier. This is only possible with callable bonds, which give the issuer the right to redeem the bonds before maturity. The callable period is pre-determined, and when it is reached, the issuer may exercise the call option and pay the principal earlier, saving on future coupon payments. After this, they may issue new adjusted bonds. Another version of this is the make-whole call. This works similarly but the bondholders are also compensated for the coupons they would have missed. Another method is to gradually pay parts of the principal amount across the period instead of the final large payment. This is called a sinking fund and it lowers credit risk for investors and reduces the massive burden at the end. The final method of alternative resolution is making a tender offer. When interest rates fall, the company may make an offer to buy back the bonds they issued. This may be to reduce expenditure on coupons or to even reduce debt. In short, these measures exist to avoid unnecessary destruction of the contractual relationship.

This ultimately reaffirms the central principle of this entire article: defaults must be avoided whenever possible. The law provides multiple mechanisms to adapt, maintain and conclude this relationship effectively to ensure value creation, or at the least, minimal value reduction.