What Is a Sinkable Bond?
A sinkable bond is a type of debt that is backed by a fund set aside by the issuer. The issuer reduces the cost of borrowing over time by buying and retiring a portion of the bonds periodically on the open market, drawing upon the fund to pay for the transactions. The bonds usually have a provision that allows them to be repurchased at the prevailing market rate.
Sinkable bonds are a very safe investment for the bond investor because they are backed by cash. However, their return is uncertain because it is dependant on the direction of bond prices in the market.
Understanding the Sinkable Bond
From the viewpoint of the corporations and municipalities that issue them, an advantage of sinkable bonds is that the money can be repaid entirely or in part if interest rates fall below the nominal rate of the bond. They can then refinance the balance of the money they need to borrow at a lower rate.
- Sinkable bonds are backed by a fund that is used to repurchase a portion of the bond issue periodically.
- From the issuer's view, sinkable bonds can be a cheaper way to borrow money.
- From the investor's view, sinkable bonds are a low-risk investment but their yield may be disappointing.
In addition, the issuers are paying off their loans and the interest on them in installments, gradually reducing the sum due at the end of the term.
Calculating Yield to Average Life
Because sinkable bonds typically have shorter durations than their maturity dates, investors may calculate a bond’s yield to average life when determining whether to purchase a sinkable bond. The yield to average life takes into consideration how long a bond may have before retirement and how much income the investor may realize.
Sinkable bonds typically have a provision allowing them to be repurchased at par plus the prevailing market interest rate.
The yield to average life is also important when bonds with sinking funds are trading below par, since repurchasing the bonds gives a bit of price stability.
Example of a Sinking Bond
Say Mars Inc. decides to issue $20 million in bonds with a maturity of 20 years. The business creates a $20 million sinking fund and a call schedule for the next 20 years. On the anniversary date of each bond being issued, the company withdraws $1 million from the sinking fund and calls 5% of its bonds.
Because the sinking fund adds stability to the repayment process, the ratings agencies rate the bonds as AAA and reduce the interest rate from 6.3% to 6%. The corporation saves $120,000 in interest payments in the first year and additional money thereafter.
The enhanced repayment protection offered by the sinking funds is attractive to investors seeking a safe investment. However, investors may have concerns over the bonds being redeemed before maturity, as they will lose out on interest income.
Companies are required to disclose their sinkable bond obligations through their corporate financial statements and prospectus.