Tuesday, September 8, 2009

Sinking fund and refunding provisions

Most corporate bonds issued in the U.S. carry sinking fund provisions designed to insure that the issuing company will be able to pay off the bonds when they come due. Periodic payments are made into the sinking fund on a schedule which usually is related to the depreciation of the assets supported by the bonds. A trustee is charged with the responsibility of making sure that the user actually places the right amount of money in the sinking fund each time a payment is due. Periodically, a portion of the bonds outstanding may be retired from monies accumulated in the fund. The trustee will call in selected bonds at par or at par plus a designated call premium.
The majority of corporate bonds issued in recent years have also included refunding provisions which allow the issuer to retire bonds in advance of maturity (usually at a premium of 5 to 10 percent over par value) by issuing new securities carrying a lower interest rate. For utility bonds the refundability option generally may be exercised after 5 years, while industrial bonds usually permit refunding after 10 years. Refunding provisions have been one of the most important devices used by U.S. Corporations in recent years to shorten the actual maturity of corporate bonds in an era of rapid inflation and high borrowing costs. Just as with call privileges, investors usually demand higher yields on refundable bonds to protect themselves against declining interest rates.

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