Sinking Fund Call
What Is a Sinking Fund Call?
A sinking fund call is a provision that permits a bond issuer to buy back its outstanding bonds before their maturity date at a pre-set price.
The money that is utilized for the buyback comes from a sinking fund, an amount that is set beside the issuer's earnings specifically for use in security buybacks.
A sinking fund provision in a bond adds an element of uncertainty about whether the bond will keep on paying a return until its maturity date. That is viewed as an extra risk for investors.
- A sinking fund call permits a bond issuer to recall a portion of its bonds, or every one of them, before the maturity date.
- The bond investor receives the principal and the accrued interest however not the future interest payments.
- Bonds that have this provision pay a higher return since this element of vulnerability is added to the investment.
Understanding a Sinking Fund Call
Securities that have a sinking fund call provision have higher respects compensate for the extra risk associated with the call provision. The call provision is generally at par value with the bonds to be called not entirely settled by parcel. Investors who receive a sinking fund call will be paid any accrued interest plus the principal investment. In any case, they won't receive the interest paid in the accompanying periods.
The sinking fund is an annual reserve where a bond issuer is required to set aside periodic installments that will be utilized exclusively to pay the costs of calling bonds or purchasing bonds in the open market.
The fund is most frequently seen in trust indentures for bonds that have a mandatory redemption clause. Such a clause requires the issuer to retire a part of its bonds, or every one of them, prior to their maturity date.
The Advantage to the Issuer
Borrowers who opt to have a sinking fund call relieve interest rate risk. That is, assuming interest rates fall, they can buy back their outstanding securities and issue new ones with lower interest rates.
In any case, that means their bond investors are confronted with reinvestment risk in a low-interest environment. In the event that their bonds are called, they might be forced to reinvest their money at a lower interest rate.
A sinking fund call lessens credit risk since the presence of the fund infers that repayment of the debt has been accommodated and, consequently, the issuer's payment obligations are secured.
Notwithstanding, sinking funds can possibly devalue given that they can underperform in a sluggish economy.
Illustration of a Sinking Fund Call
For instance, a company might issue a 10-year bond with a $100 million par value. It is required to buy back 10% of the outstanding bonds consistently.
To meet its interest and principal payment obligation for every period it must recover the bonds, the company will set up a sinking fund through a custodial account in which it deposits 10% of the total value, or $1 million, consistently.
A sinking fund call permits an issuer to recover its existing debt early, involving money that has been set to the side in the sinking fund. All it is the issuer's call of a portion or its outstanding callable bonds to fulfill the mandatory requirement of the sinking fund.
