Called Bond Vs. Sunk Bond

by Eric Bank Google

    A common feature of all bonds is a specified maturity date. On that date, the bond is retired, and the bondholder receives the face value and any remaining interest due. However, bond issuers often require the flexibility to retire some or all of the bonds from a particular issue before the maturity date. Issuers can accomplish early retirement through a bond call or a buyback program, with or without a sinking fund. Sometimes, the issuer will employ multiple retirement strategies at the same time.

    An issuer may embed a call option in a bond at the time of issue. A call option gives the issuer the right to forcibly retire some or all of the bonds from the issue on or after one or more call dates. The bond agreement, or indenture, will spell out the terms of the call option, including the price the issuer will pay when calling the bond. If your bond is called, you have no recourse but to redeem it for the call price. Investors dislike call options, because it reduces the number of interest payments they would otherwise receive from a bond. Therefore, callable bonds sell for less than non-callable ones.

    A company may wish to retire a bond issue in installments. For example, XYZ Corp issues 1 million 10-year bonds, each priced at $1,000, on July 1. It intends to retire 100,000 of the bonds in each of the next 10 years on the annual anniversary of the issuance. The bond indenture will specify the dates and the prices for each of nine bond calls. The actual bonds called each year are chosen by a lottery based on the bond serial number. XYZ sets the call price for the first year at $1,005, and reduces it by a half dollar each year thereafter. The last set of 100,000 bonds is retired on the maturity date for face value, without the need for a call.

    A corporation can establish a sinking fund to set aside the money necessary for a multiple call schedule. In effect, it is a cash reserve dedicated to retiring the bond issue. Unless specified in the bond indenture, a sinking fund is optional. The fund may be set up all at once or as needed. Sinking funds enhance the probability that the issuer will be able to pay for the bond redemptions. As each year passes, the corporation needs to spend less on interest payments, because fewer bonds remain in circulation. As the annual interest expense decreases, so does the likelihood that the issuer will default on the remaining bonds. Therefore, sinking funds help lower the credit risk assumed by the remaining bondholders.

    Sinking funds can be used with non-callable as well as callable bonds. The issuer can execute a bond retirement schedule by using the sinking fund to enter the marketplace and buy back the bonds at their current price. It would then retire the bonds it repurchased. Issuers can also choose to buy back callable bonds if the market price is lower than the call price. Some bond indentures require the issuer to retire the bonds at the lesser of the market and call prices, while others leave it to the discretion of management. A corporation is always free to buy back its bonds in the marketplace any time it wishes, with or without a sinking fund.

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    About the Author

    Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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