The indenture is the binding legal contract between a bond issuer and its bondholders, executed through a trustee (typically a major bank or trust company) that acts as the legal representative of the noteholder group. For high yield bonds, the indenture is the primary document governing the relationship — defining payment terms, security (if any), covenant restrictions, events of default, and the rights of holders to enforce their claims.
The covenant package in a high yield indenture differs significantly from bank credit agreements. Most high yield covenants are "incurrence-based" — they restrict certain actions only if a financial test is not satisfied at the time of the action, not on an ongoing quarterly basis. The most important high yield covenant is the debt incurrence covenant: the issuer cannot incur additional debt unless, after giving effect to the new debt, a fixed charge coverage ratio test (EBITDA/fixed charges) is satisfied or the new debt fits within a permitted basket. This test limits the accumulation of additional leverage but does not require the issuer to maintain the ratio going forward.
The restricted payments covenant limits cash leakage from the issuer's restricted group — the entities covered by the indenture — through dividends, share repurchases, investments in unrestricted subsidiaries, and junior debt payments. Restricted payments are subject to a capacity test (a basket calculated based on EBITDA and available cash) and a conditions test (the incurrence test must be satisfied, no default, etc.). Understanding the restricted payments basket is essential for assessing the potential for cash to flow to equity holders before debt is repaid.
The lien covenant limits additional liens on the issuer's assets beyond a permitted amount. This protects unsecured noteholders from being effectively subordinated to later secured creditors. The asset sale covenant requires proceeds from dispositions above a threshold to be either reinvested in the business or applied to debt repayment — protecting lenders from asset stripping.
Events of default in bond indentures typically include payment failure (with a grace period), covenant violations, cross-defaults to other material debt, bankruptcy, and ERISA violations. Acceleration upon default requires holders of 25% or more in principal amount to give notice; a majority (50%+) can rescind an acceleration if the default is cured. This structure differs from bank loans, where acceleration requires a majority lender vote.