What it is:
An indenture agreement is the formal contract between a bond issuer and the bondholders. It sets forth the details of all the terms and conditions of the bonds, such as the exact day of their maturity, the timing of the interest payments and how they are calculated, and the details of any special features.
How it works (Example):
Indenture agreements vary from issue to issue, but in general they are very technical documents. This is because the role of the indenture is to prescribe every detail of the bond's provisions as well as the day-to-day management of the bond.
For example, the indenture gives bondholders exact instruction about whom to contact if the bonds are called and describes the procedures for tendering their certificates and receiving their compensation. Other details in a bond indenture include a description of how the bond certificates will look and what language will appear on them, as well as a list of financial covenants the issuer must abide by and the formulas for calculating whether the issuer is abiding by the covenants.
Since indenture agreements can be very technical, the issuer usually appoints a trustee (usually a large bank) to act on behalf of the bondholders in certain situations, including making sure the issuer is abiding by the covenants, paying interest on time, collecting and distributing certificates, and so forth.
Why it Matters:
The indenture is the legal document that is ultimately referred to when there is a conflict between issuers and bondholders. For this reason, it is important to understand that a prospectus is not the same as an indenture.
Although it may be easier reading, the prospectus is a summary description of the terms and conditions of the issue, whereas the indenture is the actual legal document by which the issuer is beholden to the bondholders.