What Is a Sinkable Bond?
A sinkable bond is backed by a fund that sets aside money to ensure principal and interest payments are made by the issuer as promised. Companies are required to disclose their sinkable bond obligations through their corporate financial statements and prospectus. Because issuers set aside money in their sinking fund to repay the money owed based on the bond's par value, if interest rates fall below the nominal rate of the bond, the company may repay all or part of the amount owed and refinance the remaining balance.
Sinkable Bonds Explained
Businesses and municipalities may create sinking funds for paying off bonds in installments and reducing interest payments as a means of saving money. For example, Corporation A issues $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 for the first year and additional money afterward.
The enhanced repayment protection offered by the sinking funds is attractive to investors seeking more stability. However, investors may have concerns over the bonds being redeemed before maturity, as investors may lose out on interest income.
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. 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 Sinkable Bond
In March 2016, Empresa Mocambicana de Atum SA, or Ematum, a state-owned tuna-fishing company in Mozambique, requested to exchange $773.5 million of sinkable bonds for longer-term securities as a means of reducing annual interest expenses. The bonds’ yields decreased 2.4% while prices increased 4.9%. The government reissued bonds maturing in 2023, three years later than the retired bonds were set to mature.
After Ematum made principal and interest payments, the company anticipated holding $697 million in outstanding bonds, resulting in positive amortization. However, Standard & Poor's viewed the restructuring and maturity date extension in a manner similar to default and anticipated lowering the bonds’ B- credit rating.