“The price at which bonds are redeemed under a sinking fund provision is typically par but can be different from par. If the market price is less than the sinking fund redemption price, the issuer can satisfy the sinking fund provision by buying bonds in the open market with a par value equal to the amount of bonds that must be redeemed. This would be the case if interest rates had risen since issuance so that the bonds were trading below the sinking fund redemption price.”
Can anyone explain to me, does sinking fund redemption price mean the principal that is being returned? Why does the issuer need to buy bonds in the open market if the market price is less than the sinking fund redemption price?
Suppose an issuer (Company A) is issuing bonds worth 3 Billion dollars. The period is 10 years.
At the end of 10 years the issuer should be certain that it is liquid enough to make the ballon payment of 10 bil., which is obviously a problem. So what they do is they mention in the indenture that they will be retiring 200 mil worth of the principal every year, say 5 years from now. The holders are choosen via a lottery. This is sinking fund. They are slowly retiring part of the debt so that they can cut down on the ballon payment at the end. (This is different from amortisation).
The issuer mentions in the indenture that they will be paying par value for retiring the debt, or something else. But i think it is usually the par value.
Under sinking fund provision , The redempation is done in phased manner instead of going for the total face value at one go . Like if a redemption is going to happen after 10 yrs. then It will be donr after every 2 yr. in phased manner. This is called sinking fund provision.
Yes, it’s the principle that is being returned. As Anand mentioned above, part of the bond issue is repurchased each year (usually starting some time after the year of issuance), to reduce the risk that the issuer won’t be able to retire the bonds at maturity.
As a simple example, suppose that a company issues $10 million in bonds, with a sinking fund provision that they retire 10% of the original issue each year. Thus, each year, the company will repurchase $1 million par of its bonds from the bondholders and retire them. The idea is that it’s less risky for the company to come up with an extra $1 million each year for ten years than that they will be able to come up with an extra $10 million upon maturity.
They don’t need to do so; they choose to do so.
Let me ask you a question: if the par value of a bond is $1,000, but it’s selling on the open market at $950, which would you rather pay for it: $1,000 or $950?
Continuing my example above, the disadvantage to the issuer is that they have to come up with $1 million (or slightly less) each year for ten years. The disadvantage to the bondholders is that if the price of the bonds rises above par, they can be forced to sell back (at least some of) their bonds at par and lose out on the gains, as well as the continuing coupon payments.