Bond Indentures and Covenants

Updated for the 2026-2027 CFA® Level I curriculum.

A bond indenture records the legal terms of a bond issue. For the exam, focus on what the document contains and whether a covenant requires an action or restricts one.

Key Takeaways

• The indenture is the controlling document for a bond's contractual terms.

• It identifies payment obligations, security, covenants, and default provisions.

• Affirmative covenants require action, such as maintaining insurance.

• Negative covenants restrict action, such as taking on additional secured debt.

• Stronger bond covenants can protect investors but reduce issuer flexibility.

• A covenant does not eliminate default risk.

What You Need to Know for CFA Level I

• Identify information normally found in bond indentures.

• Classify a clause by asking whether it requires or restricts an action.

• Explain how a covenant changes the balance between creditor protection and managerial freedom.

• Separate a debt ranking from collateral pledged to the issue.

For governing law, securities regulation, and taxation, use the separate note on Legal, Regulatory, and Tax Implications for Fixed-Income Securities.

What Is a Bond Indenture?

The indenture is a legal agreement that defines the issuer's obligations and the bondholders' rights. The issuer promises to make the stated payments and follow the agreement. Bondholders supply capital and receive the contractual claim. A trustee may act on behalf of bondholders by monitoring compliance and taking specified actions after a default.

The document matters because a bond certificate or short description cannot capture every right and restriction. If a question asks where the detailed terms of a bond are recorded, the indenture is the best answer.

What Information Appears in a Bond Indenture?

Common contents include the bond's par value, coupon rate, payment dates, maturity date, and redemption terms. The indenture also explains whether assets secure the issue, how the bond ranks among other claims, and which actions count as default.

Covenants govern the issuer's conduct while the debt is outstanding. Default provisions may define missed payments, covenant breaches, available cure periods, and remedies. These terms allow investors to assess both promised cash flows and legal protection.

Affirmative vs Negative Covenants

An affirmative covenant states what the issuer must do. Typical examples include paying interest on time, maintaining insurance, keeping proper records, paying taxes when due, and providing audited financial statements.

A negative covenant states what the issuer must not do or may do only within a limit. Examples include limits on additional borrowing, restrictions on asset sales, and limits on distributions to shareholders. The word “agrees” does not make a covenant affirmative. Classify the economic action that follows.

How Covenants Affect Credit Protection

Tighter covenants can reduce actions that transfer value away from bondholders. They may limit leverage, protect key assets, or improve the flow of information. This can strengthen creditor protection.

Restrictions also reduce the issuer's operating and financing flexibility. An issuer may accept tighter terms to obtain funding on better terms, while investors may accept looser terms when other protections are strong. The exam often tests this tradeoff, not an assumption that more restrictions are always optimal.

Illustrative Example

North Harbor Ltd. issues a five-year unsecured bond with four clauses:

1. Supply audited annual statements. This is affirmative because the issuer must perform an action.

2. Maintain property insurance. This is affirmative because continued coverage is required.

3. Limit additional secured borrowing to 20% of assets. This is negative because the issuer's financing action is restricted.

4. Do not sell the main production facility without bondholder approval. This is negative because an asset sale is prohibited unless a condition is met.

For a CFA Level I candidate, the reliable test is whether the clause requires conduct or limits conduct.

Common Exam Traps

• Calling every covenant affirmative because the issuer agreed to it. Affirmative covenants require actions such as reporting; negative covenants restrict actions such as pledging assets or taking on more debt.

• Assuming a covenant eliminates default. It may constrain behavior or provide remedies after a breach, but it cannot ensure the issuer has enough cash to meet every obligation.

• Confusing indenture terms with regulatory rules. The indenture is the contract governing a particular bond, while laws and regulations apply through a separate legal framework.

• Treating secured and senior debt as identical. Security concerns a claim on pledged collateral; seniority concerns claim priority. A bond's position depends on both its collateral rights and ranking.

Practice Question

A bond agreement prohibits the issuer from pledging key assets to support new debt. The provision is best classified as:

1. an affirmative covenant

2. a negative covenant

3. a coupon provision

FAQs About Bond Indentures and Covenants