CFA Level I Exam · Fixed-Income Cash Flows and Types

Bond Indenture, Covenants and Bond Taxation

Updated 7 October 2026 · Fact-checked

A bond indenture is the legal contract between issuer and bondholders. It lists the bond terms, the issuer's duties (affirmative covenants) and its restrictions (negative covenants). A trustee monitors compliance. Interest is usually taxed as ordinary income, and a discount bond's accretion is often taxed as interest each year, though rules vary by country.

Understand Legal, Regulatory and Tax Considerations

A bond is a legal promise. The bond indenture (also called the trust deed) is the contract that sets out that promise. It states the issuer's name, the principal amount, the coupon, the maturity date, how interest and principal are paid, the collateral if any, and the covenants. It is the document a court would use if the issuer defaulted.

Investors cannot watch every issuer action, so a trustee acts for them. The trustee is usually a bank or trust company. It holds the legal title for bondholders, monitors compliance with the covenants, and takes action on bondholders' behalf if the issuer breaches them. The issuer is the borrower. The bondholder is the lender. The indenture also names the legal and regulatory setting: bonds are either registered with a securities regulator for public sale, or sold privately under exemptions. Public issues usually carry more disclosure than private placements. Issuers can also be incorporated in one country and issue in another, so the law that governs the contract matters.

Covenants protect lenders. Affirmative covenants say what the issuer must do. Examples: pay interest and principal on time, keep insurance on assets, maintain the assets, file financial statements, and comply with laws. They are usually low cost. Negative covenants say what the issuer must not do. Examples: limit additional debt, restrict dividends or share buybacks, restrict asset sales, restrict liens on assets, and restrict mergers or transactions with affiliates. They cost the issuer flexibility, but they reduce lenders' credit risk, so lenders usually require a lower yield. Stronger protection for bondholders usually means a lower yield for the issuer.

Bonds can be secured or unsecured. Secured bonds give lenders a claim on specific collateral, which improves recovery in default. A covenant breach can become an event of default if it is not cured within the grace or cure period set out in the indenture, and the trustee or bondholders may then demand repayment.

Tax follows the cash flows. In most jurisdictions, coupon interest is taxed as ordinary income. A gain or loss from selling a bond is a capital gain or loss. A bond issued below par is an original issue discount (OID) bond. In many jurisdictions, the discount is treated as interest income and accrues over the life of the bond, even though no cash arrives until maturity. The tax basis rises as the discount accretes. Bonds bought in the market at a discount can be treated differently. Some jurisdictions tax the discount as ordinary income at maturity, others as capital gain. Some bonds, such as certain government or municipal bonds, may have interest that is tax exempt. Always follow the rule the question gives you.

Key formulas to remember

Tax on coupon interest: After-tax coupon = coupon × (1 − tax rate); Use when interest is taxed as ordinary income.
OID accretion (constant-yield method): Interest income for the period = beginning carrying value × yield at issue; accretion = interest income − coupon paid; Carrying value rises toward par. Taxable interest is the full interest income, not just the cash coupon, under a constant-yield rule.
Capital gain or loss on sale: Gain or loss = sale price − tax basis; Tax basis includes accreted OID for an issue-discount bond.
Covenant types: Affirmative = must do; Negative = must not do; Negative covenants restrict issuer actions and protect lenders.

How to solve Legal, Regulatory and Tax Considerations questions

Use this method for any question on legal, regulatory and tax features of bonds.

1Identify what the question asks: a legal term (indenture, trustee, covenant) or a tax calculation.
2For covenants, ask whether the issuer is required to do something (affirmative) or prevented from doing something (negative).
3For legal questions, remember who acts for whom. The trustee acts for bondholders. The indenture binds the issuer.
4For tax questions, separate the cash coupon, any discount accretion and any gain or loss on sale.
5Apply the tax rule the question states. If none is given, treat coupon as ordinary income and sale gains as capital gains.
6Compute after-tax figures with the right rate for each component and update the tax basis if OID has accreted.
7Eliminate the two wrong options by checking direction: covenants that help lenders restrict issuers, and taxes reduce income.

Quickest way: Verb test for covenants and three-bucket test for tax

When to use it: Use when you have about 90 seconds and the question asks you to classify a covenant or compute a tax effect.

Read the covenant. If it says maintain, pay, file or comply, it is affirmative. If it says limit, restrict, prohibit or not exceed, it is negative.
For tax, split the return into three buckets: coupon, accreted discount, and sale gain or loss.
Tax each bucket at the rate given. Do not tax the same amount twice.
Pick the option whose sign and size fit. Discard any option that taxes principal repaid at par.

Common mistakes in Legal, Regulatory and Tax Considerations

Calling a restriction on dividends an affirmative covenant.
Students focus on the topic (dividends) instead of the verb.
Fix: Restrictions and limits are negative covenants. Obligations to do something are affirmative.
Thinking the trustee works for the issuer.
The issuer pays the trustee's fees.
Fix: The trustee acts for bondholders and monitors the issuer's compliance.
Taxing only the cash coupon on an OID bond.
Students link tax to cash received.
Fix: Where the rule treats the discount as interest, accreted discount is taxable each year even without cash.
Forgetting to raise the tax basis by accreted OID before computing a capital gain.
Students use the original issue price as basis.
Fix: Basis = issue (purchase) price + the accreted discount already included in taxable income. If you skip this, the accreted discount is taxed twice: once as interest and again as part of the gain.
Thinking stronger covenants make bondholders demand a higher yield.
Students confuse restrictions on the issuer with higher risk for the lender.
Fix: Stronger covenants reduce lenders' credit risk, so the yield they require is usually lower. The restrictions cost the issuer flexibility, not the lender.

Worked examples

Example 1

A bond indenture says the issuer must maintain insurance on pledged assets, file audited financial statements each year, and must not issue additional debt that ranks equally with this bond. Which statement is correct? A) All three are negative covenants. B) The first two are affirmative and the third is negative. C) The first two are negative and the third is affirmative.

Show the solution

Maintain insurance: the issuer must do it, so affirmative.
File audited statements: the issuer must do it, so affirmative.
Must not issue additional equal-ranking debt: a restriction, so negative.
Match: first two affirmative, third negative.

Answer: B

Example 2

An investor buys a 2-year zero-coupon bond at original issue for €90.70 per €100 par, a yield of 5.0% a year. Under a constant-yield rule, the discount accretes as taxable interest each year. The tax rate is 30%. What is the tax due for year 1? A) €1.36 B) €2.72 C) €4.54

Show the solution

Year 1 interest income = 90.70 × 5.0% = €4.535, about €4.54.
Tax = 4.535 × 30% = 1.3605, about €1.36.
Cash received is zero, but the accreted discount is taxable under the stated rule.
Option C (€4.54) is the pre-tax interest, not the tax. Option B (€2.72) does not match a correct year 1 tax result.
Only €1.36 is the tax on year 1 accretion.

Answer: A) Tax for year 1 is about €1.36 (taxable interest of about €4.54 at 30%).

Exam tips

Classify covenants by the verb: must is affirmative, must not is negative.
Remember the trustee represents bondholders, and the indenture is the issuer's contract with them.
In tax questions, follow the rule given in the stem. Do not import a rule from your own country.
Check that capital gains use basis adjusted for accreted discount.
With no penalty for wrong answers, always guess if unsure, after eliminating the option that taxes principal or reverses the covenant direction.

Practice questions from Fixed-Income Cash Flows and Types

Legal, Regulatory and Tax Considerations: frequently asked questions

What is the difference between affirmative and negative covenants?

Affirmative covenants require the issuer to take actions, such as paying on time and keeping assets insured. Negative covenants restrict actions, such as taking on more debt or selling key assets. Both protect bondholders.

What is a trust deed?

A trust deed is the same idea as the bond indenture in many markets: the legal contract that sets out the bond terms and the trustee's role. The wording varies by jurisdiction.

How is original issue discount taxed?

In many jurisdictions, the discount is treated as interest that accrues over the bond's life and is taxed each year, even though no cash is received. The exact rule varies, so use the one in the question.

Who enforces the covenants?

The trustee monitors compliance and acts for bondholders if the issuer breaches the covenants. The indenture sets out what actions are allowed.