Final answer:
Covenants in a bond indenture restrict a company's borrowing capacity to protect bondholders and ensure the company can meet its payment obligations. Bondholders can force a defaulting issuer into bankruptcy to recoup funds. Diversifying bonds, even junk bonds, can mitigate investment risks.
Step-by-step explanation:
The provisions in a bond indenture that limit a company's ability to borrow more money or significantly increase its risk of default are called covenants. These covenants are designed to protect bondholders by ensuring the company does not undertake excessive risk that could jeopardize its ability to make the promised payments. A bond issuer is obliged to make payments over time, and in instances other than bankruptcy, these payments are expected to be made. If a corporate bond issuer is unable to meet its obligations, bondholders have the legal right to push the company towards bankruptcy, where its assets are sold to repay them. To mitigate investment risks, especially with junk bonds, a prudent investor would diversify their bond portfolio across different companies. This strategy reduces the likelihood that all investments would fail simultaneously.