The Use of a Sinking Fund for Preferred Stocks
A preferred stock is a non-voting equity share issued by a corporation. It pays higher, fixed dividend yields relative to non-fixed common stock dividends, but usually provides lower yields than bonds issued by the same corporation. Preferred stock can be issued with a call option that permits the issuer to later buy back the shares at a pre-established price. Sinking funds are asset reserves, usually cash or bonds, that are used to guarantee funding for the repurchase of instruments such as preferred stocks, whether callable or not.
Preferred stock is “preferred” in that it has a prior claim over common stock to assets should a corporation undergo liquidation. Preferred stock dividends are set at a fixed amount, but payments may be skipped. However, common stock cannot pay dividends for the period if the preferred shares have skipped their dividends. Cumulative preferred shares require all skipped dividends be paid before common stock can resume dividend payment. Preferred stock is attractive to investors seeking high income rather than capital appreciation.
Sinking Fund Mechanics
Sinking funds generally are structured to retire a fixed number of shares each year until all are retired. Preferred-share sinking fund call provisions must be announced at the time the shares are issued. The issuer may also specify optional provisions to postpone or accelerate a call schedule. An issuer uses a lottery system to decide which shares to call each year. A sinking fund can also retire shares through open purchases rather than through calls -- in this case, the sinking fund need not be established at the time of share issuance.
Effect of Sinking Funds on Callable Preferred Share Prices
An issuer normally establishes a callable preferred security’s call price equal to the security issuance price. Higher dividend rates support higher issuance/call prices. Normally, share prices would go up or down in the secondary market depending on whether current interest rates had moved lower or higher, respectively, since the shares were issued. But because a portion of the issued shares will be called each year at the call price, callable preferred share prices are “sticky” -- they remain close to the call price rather than float freely according to current interest rates. A sinking fund increases stickiness, since the call is assured.
Effect of Sinking Funds on Non-Callable Preferred Share Prices
In contrast, an issuer retires non-callable preferred shares through open-market purchases. A buyback program may or may not be supported by a sinking fund. Open-market purchases tend to boost share prices by creating extra demand. A sinking fund increases the amount of boost, since the fund’s existence lowers the risk that the issuer will fail to execute its buyback plan. Non-callable shares do not exhibit the price stickiness observed in callable shares.
- Foundations of Finance: The Logic and Practice of Financial Management; Arthur J. Keown
- Preferred Stock Investing; Doug K. Le Du
- Sinking Funds; Edward Alsworth Ross
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