What Is a Sinking Fund Call?
A sinking fund call is a provision that allows a bond issuer to buy back its outstanding bonds before their maturity date at a pre-set price.
The money that is used for the buyback comes from a sinking fund, an amount that is set aside from the issuer's earnings specifically for use in security buybacks.
A sinking fund provision in a bond adds an element of doubt over whether the bond will continue to pay a return until its maturity date. That is seen as an additional risk for investors.
- A sinking fund call allows a bond issuer to recall a portion of its bonds, or all of them, before the maturity date.
- The bond investor receives the principal and the accrued interest but not the future interest payments.
- Bonds that have this provision pay a higher return because this element of uncertainty is added to the investment.
Understanding a Sinking Fund Call
Securities that have a sinking fund call provision have higher yields to make up for the additional risk associated with the call provision. The call provision is generally at par value with the bonds to be called and is determined by lot. Investors who receive a sinking fund call will be paid any accrued interest plus the principal investment. However, they will not receive the interest paid in the following periods.
The sinking fund is an annual reserve in which a bond issuer is required to make periodic deposits that will be used only to pay the costs of calling bonds or purchasing bonds in the open market.
The fund is most often 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 all of them, prior to their maturity date.
The Advantage to the Issuer
Borrowers who opt to have a sinking fund call mitigate interest rate risk. That is, if interest rates fall, they have the ability to buy back their outstanding securities and issue new ones with lower interest rates.
However, that means their bond investors are faced with reinvestment risk in a low-interest environment. If their bonds are called, they may be forced to reinvest their money at a lower interest rate.
A sinking fund call reduces credit risk since the existence of the fund implies that repayment of the debt has been provided for and, therefore, the issuer's payment obligations are secured.
However, sinking funds have the potential to depreciate given that they can underperform in a slow economy.
Example of a Sinking Fund Call
For example, a company may issue a 10-year bond with a $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 must redeem 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, 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.