1.3 Legal, Regulatory and Tax Considerations on the Issuance and Trading of Fixed Income Securities

1.3.1   Bond Indenture

• A bond indenture, also known as a trust deed is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders.
• The indenture is written in the name of the issuing entity and details features of the bond issue, such as par value, coupon rate and frequency, maturity date, and the funding sources for the interest and principal repayments, as well as any collaterals, covenants, and credit enhancements.
  • Collaterals are assets or financial guarantees underlying the debt obligation above and beyond the issuer’s promise to pay.
  • Credit enhancements are provisions that may be used to reduce the credit risk of the bond issue.
  • Covenants are clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform.

Functions of a Bond Indenture

1. Legal identity of the bond issuer and its legal form: The indenture serves to identify the legal entity behind the issue. The issuer is the one legally liable for the repayment of the principle and payment of the interest due on the bond.
   • Sovereign bonds are usually issued by the national governments through their treasuries who manages the national budget.
   • In case of Corporate bonds the issuer might be a holding company or a subsidiary.
   • For securitised bonds, the legal obligation usually lies with special purpose vehicles (SPV). Special purpose vehicles (or entities) are thinly capitalized, with no independent management or employees, and have no purpose other than the transactions for which they were created.
2. Sources of repayment proceeds: bond indenture stipulates the purpose of the borrowing and sources for repaying the debt once due.
   • Sovereign bonds- Sovereign bonds are backed by the “full faith and credit” of the national government and thus by that government’s ability to raise tax revenues and print money.
   • Non-sovereign government bonds- The major sources for repayment include the general taxing authority of the issuer, the cash flows of the project the bond issue is financing, and special taxes or fees established specifically for the purpose of funding the payments of interest and principal.
   • Corporate bonds – The source of payment for corporate bonds is the issuer’s ability to generate cash flows, primarily through its operations.
   • Securitisations typically rely on the cash flows generated by one or more of the underlying financial assets that serve as the primary source for the contractual payments to bondholders rather than on the claims-paying ability of an operating entity.
3. Asset or collateral backing: Collateral backing is a form of credit enhancement – reduction of credit risk. There are several types of collateral backing with varying quality such as: mortgages, equipment or other physical assets, financial assets, among others.

Other ways of managing risk include:

1. Seniority ranking: Secured, unsecured, or subordinate (junior).
   • Secured bonds are backed by assets or financial guarantees pledged to ensure debt repayment in the case of default.
   • Unsecured bonds have no collateral; bondholders have only a general claim on the issuer’s assets and cash flows.
   • Subordinate (junior) bonds have a lower order claim on the issuer’s assets and cash flows than other bonds.
2. Credit enhancement: internal or external.
   • Internal credit enhancement relies on structural features regarding the priority of payment or the value of the collateral.
   • External credit enhancement refers to guarantees received from a third party, often called a “guarantor.” It might be in the form of a surety bond or a letter of credit.
3. Bond covenants: bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. These covenants can be either affirmative (positive) or Prohibitive (negative). (See next section).

1.3.2   Affirmative and Negative Covenants

Affirmative covenants enumerate what issuers are required to do. Affirmative covenants are typically administrative in nature.

For example, frequently used affirmative covenants include what the issuer will do with the proceeds from the bond issue and the promise of making the contractual payments. The issuer may also promise to comply with all laws and regulations, maintain its current lines of business, insure and maintain its assets, and pay taxes as they come due.

Negative covenants stipulates what issuers are prohibited from doing.

Examples of negative covenants include restrictions on debt, negative pledges, restrictions on prior claims, restrictions on distributions to shareholders, restrictions on asset disposals, restrictions on investments, and restrictions on mergers and acquisitions.

1.3.3   Effect of Legal, Regulatory and Tax Considerations

Legal and Regulatory Considerations

Fixed-income securities are subject to different legal and regulatory requirements depending on where they are issued and traded as well as on who holds them.

There are no unified legal and regulatory requirements that apply globally.

The global bond-markets consist of national bond markets and the Eurobond market.

A national bond market includes all the bonds that are issued and traded in a specific country and denominated in the currency of that country.

Bonds issued by entities that are incorporated in that country are called “domestic bonds,” whereas bonds issued by entities that are incorporated in another country are called “foreign bonds.”

Eurobonds are typically less regulated than domestic and foreign bonds because they are issued outside the jurisdiction of any single country. They are usually unsecured bonds and can be denominated in any currency, including the issuer’s domestic currency.

A global bond is issued simultaneously in the Eurobond market and in at least one domestic bond market.

Tax Considerations

Just as with legal and regulatory requirements, tax treatment around the world varies from country to another. In most countries however subject Interest payments and capital gains to taxation.

• The income portion of a bond investment is typically taxed at the ordinary income tax rate. Tax-exempt securities and entities (holders) are the exception to this rule.
• A tax on capital gains may apply if the bond sale price exceeds the bond purchase price.

The original issue discount (difference between the par value and the original issue price) might be subject to a tax for discount bonds (such as zero-coupon bonds).

Some jurisdictions also have tax provisions for bonds bought at a premium. They may allow investors to deduct a prorated portion of the amount paid in excess of the bond’s par value from their taxable income every tax year until maturity.

Interest income received by holders of municipal bonds issued in the United States is often exempt from federal income tax and from the income tax of the state in which the bonds are issued.

In Kenya, tax rates on interest is graduated, with bonds of less than 10 years tenor-on-issue, paying 15% and those over 10 years tenor-on-issue rate at 10%.