Can you help me to understand sinking funds with a simple example.
http://en.wikipedia.org/wiki/Sinking_fund
Basically say you have a bond outstanding that you have to redeem in 5 years. Now that’s a lot of cash to have to cough up at one point so what you can do is set aside a little bit regularly over the next 5 years so that you can use the money to redeem the bond. Basically a corporate piggy bank.
With a sinking fund they’re doing more than merely setting aside money to redeem the bonds; they’re acutally redeeming them. Paying them off. Pfft, gone!
Is there is a way to give numerial example
XYZ Corporation issues $5,000,000 par of 5-year, 6-% coupon, semiannual pay bonds, with a sinking provision that 20% ($1,000,000 par) must be retired each year.
One year from the date of issuance, XYZ must pay off $1,000,000 par in bonds. If the bonds are selling on the market for less than par, then their best approach is to buy the bonds in the market (for less than $1,000,000) and deliver them to the turstee for retirement. If the bonds are selling for more than par, then bonds totaling $1,000,000 par will be selected at random, and the owners of those bonds are required to sell them to XYZ at par.
The same happens two years from the date of issuance, and three years, and four years. After five years there is only $1,000,000 par outstanding, and those bonds will mature and be paid off.
Thank you all.
My pleasure.