Although sinking funds are designed to protect bondholders by ensuring that an is-
sue is retired in an orderly fashion, you should recognize that sinking funds can work to
the detriment of bondholders. For example, suppose the bond carries a 10 percent inter-
est rate, but yields on similar bonds have fallen to 7.5 percent. A sinking fund call at par
would require an investor to give up a bond that pays $100 of interest and then to rein-
vest in a bond that pays only $75 per year. This obviously harms those bondholders
whose bonds are called. On balance, however, bonds that have a sinking fund are re-
garded 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 sink-
ing funds.
Other Features
Several other types of bonds are used sufficiently often to warrant mention. First,
convertible bondsare bonds that are convertible into shares of common stock, at a
fixed price, at the option of the bondholder. Convertibles have a lower coupon rate
than nonconvertible debt, but they offer investors a chance for capital gains in ex-
change for the lower coupon rate. Bonds issued with warrantsare similar to convert-
ibles. Warrants are options that permit the holder to buy stock for a stated price,
thereby providing a capital gain if the price of the stock rises. Bonds that are issued
with warrants, like convertibles, carry lower coupon rates than straight bonds.
Another type of bond is anincome bond,which pays interest only if the interest is
earned. These securities cannot bankrupt a company, but from an investor’s standpoint
they are riskier than “regular” bonds. Yet another bond is theindexed,orpurchasing
power, bond,which first became popular in Brazil, Israel, and a few other countries
plagued by high inflation rates. The interest rate paid on these bonds is based on an in-
flation index such as the consumer price index, so the interest paid rises automatically
when the inflation rate rises, thus protecting the bondholders against inflation. In Janu-
ary 1997, the U.S. Treasury began issuing indexed bonds, and they currently pay a rate
that is roughly 1 to 4 percent plus the rate of inflation during the past year.
Define floating rate bonds and zero coupon bonds.
What problem was solved by the introduction of long-term floating rate debt,
and how is the rate on such bonds determined?
Why is a call provision advantageous to a bond issuer? When will the issuer initi-
ate a refunding call? Why?
What are the two ways a sinking fund can be handled? Which method will be
chosen by the firm if interest rates have risen? If interest rates have fallen?
Are securities that provide for a sinking fund regarded as being riskier than
those without this type of provision? Explain.
What is the difference between a call for sinking fund purposes and a re-
funding call?
Define convertible bonds, bonds with warrants, income bonds, and indexed
bonds.
Why do bonds with warrants and convertible bonds have lower coupons than
similarly rated bonds that do not have these features?
Bond Valuation
The value of any financial asset—a stock, a bond, a lease, or even a physical asset such
as an apartment building or a piece of machinery—is simply the present value of the
cash flows the asset is expected to produce.
Bond Valuation 155
Bonds and Their Valuation 151
