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CFA Level 1 - Refunding, Prepayments and Sinking Fund Provisions
REFUNDING
The refunding of an issue is the replacement of a current high coupon rate bond. This is done by issuing newer bonds at a lower coupon rate. With regards to a callable issue, refunding offers little protection to a holder. At least with a callable bond the holder has a date on which the call will occur. The refunding could occur as soon as it becomes advantageous to the issuer to replace older, higher rate bonds.
Prepayments
This form of redemption occurs in ABS and MBS securities. In this instance the investor could receive additional principal payments before the maturity date. For example, a homeowner with a mortgage payment of $500 a month could pay more than that amount, say $700 a month. This additional $200 would constitute a prepayment of principal. If this were to happen in the payment of a bond, the bond would be redeemed before maturity.
Sinking Fund Provisions
This helps redeem and retire bonds. It requires an issuer to retire or pay for the retirement of a specific portion of the issue at certain times. This helps reduce credit risk by having something in the “kitty” each year as a protection against a default. It can be structured to retire the entire issue at its maturity date or only a portion of the balance of the issue. If provision is only for a balance of the issue, the final payment is paid by a balloon payment.
Next: CFA Level 1 - The Importance of Embedded Options
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