Bond Terminology

Indenture Agreement the master agreement between the bond issuer (borrower)
and investors. It is a highly stylized document, parts of which are extracted and
included in Moodys and/or Standard & Poors description of the bond.
Covenants are the sections of the indenture agreement. These range from the
mundane (the dates when interest is paid) to those items that are extremely critical
for valuation, several of which are listed below.
Accelerator clause one of the covenants in a standard indenture agreement (and
most loan contracts, go read your own) which makes the entire amount of the
issue due immediately when the borrower fails to perform under any of the
covenants. Thus, if the borrower isnt able to pay interest it is almost certainly
going to be unable to pay the principal amount too. The accelerator clause
ensures the borrower will need to declare bankruptcy or be forced into it when
any of the covenants are violated.
Trustee one of the covenants which names a guardian for the bondholders. The
trustee is almost always a corporation (which is a legal person in the United
States) and almost always a bank. The trustee monitors the performance of the
borrower to ensure that all of the covenants are being met. If the firm should fail
to meet a covenant this would spur the trustee into action (see above).
Sinking Fund a covenant that provides a mechanism for ensuring that some or
all of the funds necessary to pay off the principal amount a maturity will be
available. The borrower makes periodic payments of a specified amount of cash,
or par value of the outstanding bonds, to the trustee. The trustee will take the cash
and typically invest the funds in U.S. government bonds (which will earn interest
that will be available to pay off the bonds at maturity). The borrower will deliver
bonds instead of cash when they can buy their bonds at a discount to par value.
Collateral the asset(s) named by the borrower that can be seized by the bond
holders should the borrower default. In the case of the default the trustee would
sell the asset(s) and the proceeds would be used to help pay off the bonds. If the
proceeds from the sale of the collateral is insufficient to pay off the bonds the
remainder becomes a general liability for the company (like suppliers and bonds
that have no collateral).
Call/Put provisions a call provision gives the borrower the opportunity to pay
off the bonds before maturity at a specified price (normally a small premium to
par value). The call usually has a limited life (e.g. years 3-6 for a bond with a 20
year maturity). The firm will call the bond, even paying a premium, if interest
rates have declined significantly (just like homeowners who refinance their
homes). A put provision gives the bondholders the opportunity to sell back the
bonds to borrower (getting their money back). Bondholders will do this when
interest rates have risen (so they can reinvest in a bond with a higher coupon) or
when the bondholder is concerned that the borrower is likely to default.
Debentures the name given to bonds that do not have collateral behind them.
Subordinate Debentures these bonds are designated by the borrower to have an
interior priority to regular debentures on the chance that the firm goes bankrupt.

Corporate Mortgage Bonds (also CMO) this is the name generally given to
bonds with real assets (real estate, buildings, and the permanent attachments
thereto) serving as collateral standing behind them.
Serial Bonds these are bonds that will be paid off prior to maturity. The
borrower can specify the order (by serial number) in which bonds will be paid off.
Conversely, the borrower can designate the trustee to hold a lottery and determine
which bonds are paid off.
Asset-backed securities (e.g. equipment) this is the name given to bonds with
non-real estate assets backing the bonds as collateral. There is basically no limit
to the kinds of things that can be used as collateral whether investors will find
the collateral reduces the risk of holding the bonds is a very different question.
Auction-rate a variable interest rate bond, where the interest rate is determined
by a periodic auction held by the trustee (e.g. weekly, monthly, quarterly). Should
there not be sufficient buys for all of the bonds outstanding the auction is deemed
to have failed. The borrower normally maintains a standby line of credit in order
to make sure that they do not have to repay the bonds out of their cash account.
However, the interest rate charged by the bank will normally be much higher than
the rate the borrower was paying.
Inflation-indexed the interest on the borrowing is variable and it moves up and
down with a specified price index.
Convertible bonds the bondholder gets the right to convert the bonds into stock,
almost always common stock of the borrower, but sometimes preferred stock or
the stock of another company that the borrower had previously acquired. The
number of shares that a bond can convert into is specified, thus, when we divide
the par value (e.g. $1000) by the number of shares we obtain the break-even
price of the securities. Once the stock rises above the break-even level the value
of the bonds will move up and down with the value of the underlying stock. The
conversion is a one-time, one-way transaction once a bondholder accepts stock
they can not get their bond back. Thus, even when the stock price rises above the
break-even amount, most bondholders wont exercise their option to convert into
stock unless they are forced to by a call provision (see above). Almost all
convertible bonds has a call provision included in the indenture agreement.