DEFINITION of Sinking Fund Call
Sinking fund call is a provision allowing a bond issuer the opportunity to buy outstanding bonds from bondholders at a set rate, using money (a sinking fund) from the issuer's earnings saved specifically for security buybacks. Because it adds doubt for investors over whether the bond will continue to pay until its maturity date, a sinking fund call is seen as an additional risk for investors.
BREAKING DOWN Sinking Fund Call
A sinking fund is an annual reserve in which an issuer is required to make periodic deposits that will be used to pay the costs of calling bonds or purchasing bonds in the open market. The fund is mostly seen in trust indentures for bonds that have a mandatory redemption clause. Mandatory redemption for a bond requires the issuer to retire a part of or all of the bonds prior to maturity. For example, a company issues a 10-year bond with $100 million par value. It is required to buy back 10% of the outstanding bonds every year. To meet its interest and principal payment obligation for each period it redeems the bonds, it’ll set up a sinking fund through a custodial account with a trustee in which it deposits 10%, or $1 million, every year.
A sinking fund call allows an issuer to redeem its existing debt early, using money that has been set aside in the sinking fund. It is the issuer’s call of a portion or all of its outstanding callable bonds to satisfy the mandatory requirement of the sinking fund. Securities that have a sinking fund call provision provide higher yields to make up for the additional risk associated with holding them. The call provision is generally at par value with the bonds to be called determined by lot. Investors who receive a sinking fund call will be paid any accrued interest plus the principal investment. However, they will not partake in any interest paid in the following periods.
Borrowers who opt to have a sinking fund call mitigate interest rate risk, allowing for the opportunity to buy back outstanding securities and issue new ones with lower interest rates. However, investors are faced with reinvestment risk in a low interest environment given that, if their bonds are called, they may be forced to reinvest at a lower interest rate.
A sinking fund call reduces credit risk since the fund implies that provision to repay the debt has been provided for and, therefore, payment obligations are secured. However, sinking funds have the potential to depreciate given that they can underperform in a slow economy.