Chapter 7 Bonds and Their Valuation 199some fees involved in the re! nancing, but the lower rate may be more than enough
to offset those fees. The analysis required is essentially the same for homeowners
and corporations.
7-2e Sinking Funds
Some bonds include a sinking fund provision that facilitates the orderly retire-
ment of the bond issue. Years ago! rms were required to deposit money with a
trustee, which invested the funds and then used the accumulated sum to retire the
bonds when they matured. Today, though, sinking fund provisions require the
issuer to buy back a speci! ed percentage of the issue each year. A failure to meet
the sinking fund requirement constitutes a default, which may throw the company
into bankruptcy. Therefore, a sinking fund is a mandatory payment.
Suppose a company issued $100 million of 20-year bonds and it is required to
call 5% of the issue, or $5 million of bonds, each year. In most cases, the issuer can
handle the sinking fund requirement in either of two ways:
- It can call in for redemption, at par value, the required $5 million of bonds. The
bonds are numbered serially, and those called for redemption would be deter-
mined by a lottery administered by the trustee. - The company can buy the required number of bonds on the open market.
The! rm will choose the least-cost method. If interest rates have fallen since the
bond was issued, the bond will sell for more than its par value. In this case, the
! rm will use the call option. However, if interest rates have risen, the bonds will
sell at a price below par; so the! rm can and will buy $5 million par value of bonds
in the open market for less than $5 million. Note that a call for sinking fund pur-
poses is generally different from a refunding call because most sinking fund calls
require no call premium. However, only a small percentage of the issue is nor-
mally callable in a given year.
Although sinking funds are designed to protect investors by ensuring that the
bonds are retired in an orderly fashion, these funds work to the detriment of bond-
holders if the bond’s coupon rate is higher than the current market rate. For exam-
ple, suppose the bond has a 10% coupon but similar bonds now yield only 7.5%. A
sinking fund call at par would require a long-term investor to give up a bond that
pays $100 of interest and then to reinvest in a bond that pays only $75 per year.
This is an obvious disadvantage to those bondholders whose bonds are called. On
balance, however, bonds that have a sinking fund are regarded as being safer than
those without such a provision; so at the time they are issued, sinking fund bonds
have lower coupon rates than otherwise similar bonds without sinking funds.
7-2f Other Features
Several other types of bonds are used suf! ciently often to warrant mention.^5 First,
convertible bonds are bonds that are exchangeable into shares of common stock at
a! xed price at the option of the bondholder. Convertibles offer investors the
chance for capital gains if the stock increases, but that feature enables the issuing
company to set a lower coupon rate than on nonconvertible debt with similar
credit risk. Bonds issued with warrants are similar to convertibles; but instead of
giving the investor an option to exchange the bonds for stock, warrants give the
holder an option to buy stock for a stated price, thereby providing a capital gain if
the stock’s price rises. Because of this factor, bonds issued with warrants, like con-
vertibles, carry lower coupon rates than otherwise similar nonconvertible bonds.
Sinking Fund Provision
A provision in a bond
contract that requires the
issuer to retire a portion of
the bond issue each year.Sinking Fund Provision
A provision in a bond
contract that requires the
issuer to retire a portion of
the bond issue each year.Convertible Bond
A bond that is
exchangeable at the
option of the holder for
the issuing firm’s common
stock.Convertible Bond
A bond that is
exchangeable at the
option of the holder for
the issuing firm’s common
stock.
Warrant
A long-term option to buy
a stated number of shares
of common stock at a
specified price.Warrant
A long-term option to buy
a stated number of shares
of common stock at a5 specified price.
A recent article by John D. Finnerty and Douglas R. Emery reviews new types of debt (and other) securities that
have been created in recent years. See “Corporate Securities Innovations: An Update,” Journal of Applied Finance:
Theory, Practice, Education, Vol. 12, no. 1 (Spring/Summer 2002), pp. 21–47.