Bond Sinking Fund: Pros and Cons of Investing in Bonds with Sinking Funds - FasterCapital (2024)

1. What is a bond sinking fund and how does it work?

One of the features that some bonds offer to investors is a bond sinking fund. This is a provision that requires the issuer of the bond to set aside a certain amount of money every year to repay a portion of the bond's principal before its maturity date. The purpose of a bond sinking fund is to reduce the risk of default and the amount of debt that the issuer has to pay at the end of the bond's term. A bond sinking fund can also benefit the issuer by lowering the interest rate that it has to pay to attract investors.

However, a bond sinking fund is not always advantageous for the bondholders. There are several factors that affect how a bond sinking fund works and what impact it has on the bond's value and yield. Some of these factors are:

1. The method of repayment: The issuer can either buy back the bonds from the open market or call them at a predetermined price. The former method is favorable for the bondholders, as it reduces the supply of the bonds and increases their price. The latter method is unfavorable for the bondholders, as it forces them to sell their bonds at a lower price than the market value and lose the future interest payments.

2. The timing of repayment: The issuer can either repay the bonds at regular intervals or at random dates. The former method is predictable and allows the bondholders to plan their cash flows accordingly. The latter method is unpredictable and exposes the bondholders to reinvestment risk, which is the risk of having to reinvest the proceeds at a lower interest rate.

3. The amount of repayment: The issuer can either repay a fixed amount or a variable amount of the bonds every year. The former method is stable and reduces the uncertainty for the bondholders. The latter method is volatile and depends on the issuer's financial performance, which can affect the bond's price and yield.

For example, suppose a company issues a 10-year bond with a face value of $1,000 and a coupon rate of 5%. The bond has a bond sinking fund that requires the issuer to repay 10% of the outstanding principal every year, starting from the fifth year. The issuer can either buy back the bonds from the market or call them at $1,050.

If the issuer buys back the bonds from the market, the bondholders will benefit from the increased demand and price of the bonds. The bond's yield will decrease as the bond's price increases. The bondholders will also receive the full coupon payments until the bond is fully repaid.

If the issuer calls the bonds at $1,050, the bondholders will lose the opportunity to sell their bonds at a higher price in the market. The bond's yield will increase as the bond's price decreases. The bondholders will also lose the future coupon payments that they would have received if the bond was not called.

What is a bond sinking fund and how does it work - Bond Sinking Fund: Pros and Cons of Investing in Bonds with Sinking Funds

2. Lower default risk, higher credit rating, and lower interest rate

One of the main advantages of investing in bonds with sinking funds is that they reduce the risk of default for both the issuer and the investor. A sinking fund is a provision that requires the issuer to periodically retire a portion of the outstanding bonds before the maturity date. This reduces the amount of debt that the issuer has to repay at the end of the term, and also ensures that the investor receives some return on their investment along the way.

Some of the benefits of investing in bonds with sinking funds are:

- lower default risk: By retiring some of the bonds early, the issuer reduces the likelihood of defaulting on the remaining debt. This is especially beneficial for issuers who may face financial difficulties or declining revenues in the future. For example, a company that issues bonds with a sinking fund may be able to avoid bankruptcy if its business performance deteriorates over time. On the other hand, an investor who buys bonds with a sinking fund has a lower chance of losing their principal if the issuer defaults. Even if the issuer fails to make the scheduled payments, the investor can still recover some of their money from the retired bonds.

- Higher credit rating: Bonds with sinking funds are generally considered to be safer and more creditworthy than bonds without sinking funds. This is because the sinking fund reduces the issuer's debt burden and demonstrates their commitment to repay their obligations. As a result, credit rating agencies may assign a higher rating to bonds with sinking funds, which reflects their lower default risk. For example, a bond with a sinking fund may be rated as A, while a similar bond without a sinking fund may be rated as BBB. A higher credit rating means that the issuer can borrow money at a lower cost and attract more investors.

- Lower interest rate: Bonds with sinking funds usually have a lower interest rate than bonds without sinking funds. This is because the lower default risk and higher credit rating make the bonds more appealing to investors, who are willing to accept a lower return for a lower risk. For example, a bond with a sinking fund may have an interest rate of 5%, while a similar bond without a sinking fund may have an interest rate of 6%. A lower interest rate means that the issuer can save money on interest payments and reduce their financing costs.

3. Reduced yield, early redemption risk, and reinvestment risk

While bonds with sinking funds may offer some advantages to investors, such as lower default risk and higher liquidity, they also have some drawbacks that need to be considered. These drawbacks include reduced yield, early redemption risk, and reinvestment risk. In this section, we will explore each of these drawbacks in detail and explain how they affect the bondholders.

- Reduced yield: Bonds with sinking funds typically have lower coupon rates than comparable bonds without sinking funds. This is because the issuer can lower the interest cost by using the sinking fund to retire some of the bonds periodically. For example, suppose a 10-year bond with a 5% coupon rate has a sinking fund that requires the issuer to retire 10% of the outstanding principal every year. The effective yield of this bond is only 4.55%, which is lower than the coupon rate. This means that the bondholder is receiving less income from the bond than expected.

- Early redemption risk: Bonds with sinking funds are subject to early redemption risk, which is the risk that the issuer will retire the bonds before their maturity date. This can happen either through the sinking fund provision or through a call option that allows the issuer to buy back the bonds at a predetermined price. Early redemption can be unfavorable for the bondholders, especially when the interest rates are declining. This is because the bondholders will lose the future interest payments and will have to reinvest the proceeds at a lower rate. For example, suppose a bond with a 6% coupon rate and a 10-year maturity has a sinking fund that allows the issuer to retire 20% of the principal every year. If the interest rates drop to 4% after five years, the issuer may decide to retire the remaining 50% of the principal using the sinking fund or the call option. The bondholder will then have to reinvest the money at a lower rate, resulting in a loss of income.

- Reinvestment risk: Bonds with sinking funds also face reinvestment risk, which is the risk that the bondholder will not be able to reinvest the periodic principal repayments at the same or higher rate as the original bond. This can reduce the total return of the bond and affect the bondholder's long-term financial goals. For example, suppose a bond with a 7% coupon rate and a 20-year maturity has a sinking fund that requires the issuer to retire 5% of the principal every year. The bondholder will receive $50 of principal repayment every year, in addition to the $70 of interest payment. If the interest rates fall to 5% after 10 years, the bondholder will have to reinvest the $50 at a lower rate, resulting in a lower compound interest. This will reduce the effective yield of the bond and the bondholder's wealth.

4. Corporate bonds, municipal bonds, and government bonds

One of the factors that investors should consider when choosing bonds is whether they have a sinking fund provision. A sinking fund is a pool of money that the issuer sets aside to repay the bondholders periodically, usually at a predetermined rate or schedule. This reduces the risk of default and lowers the interest rate for the issuer. However, it also has some drawbacks for both the issuer and the bondholder. In this segment, we will explore some examples of bonds with sinking funds and their pros and cons.

Some of the common types of bonds that have sinking funds are:

- corporate bonds: These are bonds issued by private companies to raise capital for various purposes, such as expansion, acquisition, or debt refinancing. Corporate bonds with sinking funds are more attractive to investors, as they offer a higher degree of security and liquidity. However, they also have some disadvantages, such as:

- The issuer may have to pay a premium to redeem the bonds before maturity, which increases the cost of borrowing.

- The bondholder may lose the opportunity to benefit from rising interest rates, as the issuer may call the bonds when the market rates are lower than the coupon rate.

- The bondholder may face reinvestment risk, as the issuer may pay back the principal earlier than expected, leaving the bondholder with excess cash that may not earn the same return as the original bond.

An example of a corporate bond with a sinking fund is the 10-year, 5% coupon bond issued by ABC Inc. in 2020. The bond has a face value of $1,000 and a sinking fund provision that requires the issuer to retire $100 worth of bonds every year, starting from the fifth year. The bond is callable at $1,050 after the fourth year.

- municipal bonds: These are bonds issued by state or local governments or their agencies to finance public projects, such as roads, schools, or hospitals. municipal bonds with sinking funds are also more appealing to investors, as they offer tax advantages and lower default risk. However, they also have some drawbacks, such as:

- The issuer may face financial constraints or political pressures that may affect its ability to meet the sinking fund obligations, which may lead to a downgrade or default of the bond.

- The bondholder may face call risk, as the issuer may redeem the bonds before maturity to take advantage of lower interest rates or to refinance the debt.

- The bondholder may face uncertainty about the timing and amount of the sinking fund payments, as the issuer may have some flexibility or discretion in how to implement the sinking fund provision.

An example of a municipal bond with a sinking fund is the 20-year, 4% coupon bond issued by the City of XYZ in 2020. The bond has a face value of $1,000 and a sinking fund provision that requires the issuer to retire 5% of the outstanding bonds every year, starting from the tenth year. The bond is callable at par after the ninth year.

- government bonds: These are bonds issued by national governments or their agencies to finance public spending, such as defense, education, or social welfare. Government bonds with sinking funds are rare, as they usually have a high credit rating and a low default risk. However, some governments may use sinking funds to enhance their fiscal discipline and credibility, or to reduce their debt burden. The pros and cons of government bonds with sinking funds are similar to those of corporate and municipal bonds, depending on the terms and conditions of the sinking fund provision.

An example of a government bond with a sinking fund is the 30-year, 3% coupon bond issued by the United Kingdom in 2020. The bond has a face value of £100 and a sinking fund provision that requires the issuer to retire £1 worth of bonds every year, starting from the fifth year. The bond is callable at £101 after the fourth year.

5. Where to find them, how to trade them, and what fees and taxes to expect

Bonds with sinking funds are a type of debt security that have a provision for the issuer to retire a portion of the bond principal before the maturity date. This reduces the risk of default for the bondholders, but also lowers the potential return. Investing in bonds with sinking funds can be a good strategy for some investors who want to diversify their portfolio and receive regular interest payments. However, there are also some drawbacks and challenges that need to be considered. In this section, we will explore how to buy and sell bonds with sinking funds, where to find them, how to trade them, and what fees and taxes to expect.

- How to buy and sell bonds with sinking funds: Bonds with sinking funds are usually sold in the primary market through underwriters or brokers who act as intermediaries between the issuer and the investor. The investor can buy the bonds at the offering price, which may be higher or lower than the face value depending on the market conditions and the credit rating of the issuer. The investor can also sell the bonds in the secondary market through brokers or dealers who facilitate the transactions between buyers and sellers. The investor can sell the bonds at the market price, which may fluctuate depending on the supply and demand, the interest rate environment, and the performance of the issuer. The investor should be aware of the call risk, which is the possibility that the issuer may redeem the bonds before the maturity date using the sinking fund. This can result in a loss of capital or a lower yield for the investor.

- Where to find bonds with sinking funds: Bonds with sinking funds are not very common in the market, as most issuers prefer to issue plain vanilla bonds without any special features. However, some issuers may choose to include a sinking fund provision to attract investors who are looking for lower risk and higher liquidity. Bonds with sinking funds are usually issued by corporations, municipalities, or agencies that have large and long-term financing needs. Some examples of bonds with sinking funds are:

- Corporate bonds: Some companies may issue bonds with sinking funds to reduce their debt burden and improve their credit rating. For instance, in 2019, Netflix issued $2.2 billion of bonds with sinking funds that required the company to retire 10% of the principal every year starting from 2021 until 2029.

- Municipal bonds: Some local governments may issue bonds with sinking funds to finance public projects such as infrastructure, education, or health care. For instance, in 2018, the New York City Transitional Finance Authority issued $1.5 billion of bonds with sinking funds that required the authority to retire 5% of the principal every year starting from 2020 until 2038.

- Agency bonds: Some government-sponsored enterprises or federal agencies may issue bonds with sinking funds to support their operations or programs. For instance, in 2020, the federal Home loan Banks issued $4 billion of bonds with sinking funds that required the banks to retire 20% of the principal every year starting from 2021 until 2025.

- How to trade bonds with sinking funds: Bonds with sinking funds can be traded in the same way as regular bonds, either through brokers or dealers who charge a commission or a markup for their services, or through online platforms or exchanges that offer lower fees and more transparency. However, there are some factors that affect the trading of bonds with sinking funds, such as:

- Liquidity: Bonds with sinking funds tend to have lower liquidity than plain vanilla bonds, as there are fewer buyers and sellers in the market. This can make it harder to find a suitable counterparty and execute a trade at a favorable price. The liquidity of bonds with sinking funds also depends on the frequency and amount of the sinking fund payments, as well as the callability of the bonds. Bonds with higher and more frequent sinking fund payments and lower callability tend to have higher liquidity than bonds with lower and less frequent sinking fund payments and higher callability.

- Price: Bonds with sinking funds tend to have lower prices than plain vanilla bonds, as they offer lower risk and lower return to the investors. The price of bonds with sinking funds also depends on the interest rate environment, the credit quality of the issuer, and the market sentiment. Bonds with sinking funds are more sensitive to changes in interest rates than plain vanilla bonds, as they have shorter effective durations and lower convexities. Bonds with sinking funds are also more sensitive to changes in the credit quality of the issuer, as they have higher exposure to the default risk and the call risk. Bonds with sinking funds are also more sensitive to changes in the market sentiment, as they have lower demand and lower liquidity than plain vanilla bonds.

- Yield: Bonds with sinking funds tend to have lower yields than plain vanilla bonds, as they offer lower risk and lower return to the investors. The yield of bonds with sinking funds also depends on the interest rate environment, the credit quality of the issuer, and the market sentiment. Bonds with sinking funds are more affected by changes in interest rates than plain vanilla bonds, as they have shorter effective maturities and lower coupon rates. Bonds with sinking funds are also more affected by changes in the credit quality of the issuer, as they have higher exposure to the default risk and the call risk. Bonds with sinking funds are also more affected by changes in the market sentiment, as they have lower demand and lower liquidity than plain vanilla bonds.

- What fees and taxes to expect: Investing in bonds with sinking funds can incur some fees and taxes that need to be considered by the investor, such as:

- Brokerage fees: buying and selling bonds with sinking funds through brokers or dealers can involve some fees that are charged by the intermediaries for their services. These fees can vary depending on the type, size, and frequency of the transactions, as well as the reputation and expertise of the brokers or dealers. The fees can be either a fixed amount or a percentage of the transaction value, and they can be either included in the price or charged separately. The investor should compare the fees of different brokers or dealers and negotiate for the best deal possible.

- Platform fees: Buying and selling bonds with sinking funds through online platforms or exchanges can also involve some fees that are charged by the providers for their services. These fees can vary depending on the features, functionalities, and security of the platforms or exchanges, as well as the type, size, and frequency of the transactions. The fees can be either a fixed amount or a percentage of the transaction value, and they can be either deducted from the account or added to the price. The investor should compare the fees of different platforms or exchanges and choose the one that suits their needs and preferences.

- Taxes: Investing in bonds with sinking funds can also incur some taxes that need to be paid by the investor to the relevant authorities. These taxes can vary depending on the type, source, and amount of the income or gains, as well as the residency and citizenship of the investor. The taxes can be either withheld at the source or reported by the investor in their tax returns. The investor should consult a tax professional or use a tax calculator to estimate their tax liability and plan their tax strategy accordingly.

6. A summary of the main points and a recommendation on whether to invest in bonds with sinking funds or not

After examining the pros and cons of investing in bonds with sinking funds, it is clear that there is no definitive answer to whether they are a good or bad option for investors. The decision depends on several factors, such as the investor's risk tolerance, time horizon, income needs, and market conditions. Here are some key points to consider before making a choice:

- Bonds with sinking funds offer lower yields than comparable bonds without sinking funds. This is because the sinking fund provision reduces the default risk of the bond issuer, making the bond more attractive to investors. However, lower yields also mean lower returns for the bondholders, especially if the interest rates rise in the future.

- Bonds with sinking funds have less price volatility than comparable bonds without sinking funds. This is because the sinking fund provision reduces the duration of the bond, which is a measure of how sensitive the bond price is to changes in interest rates. A lower duration means that the bond price will fluctuate less when the interest rates change, making the bond more stable and predictable. However, less price volatility also means less opportunity for capital gains for the bondholders, especially if the interest rates fall in the future.

- Bonds with sinking funds have a higher probability of being called than comparable bonds without sinking funds. This is because the sinking fund provision gives the bond issuer the option to redeem the bond before its maturity date, usually at par or slightly above par value. The bond issuer will exercise this option when the interest rates fall below the coupon rate of the bond, allowing the issuer to refinance its debt at a lower cost. However, a higher probability of being called also means a lower certainty of income for the bondholders, especially if they rely on the bond's cash flow for their financial needs.

Based on these points, a possible recommendation is that investors who are looking for lower risk, lower return, and more stability should consider investing in bonds with sinking funds, while investors who are looking for higher risk, higher return, and more opportunity should consider investing in bonds without sinking funds. However, this recommendation is not absolute, and investors should always do their own research and analysis before making any investment decision. Additionally, investors should diversify their portfolio across different types of bonds and other assets to reduce their overall risk and enhance their returns.

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