Retiring the Debt Gradually Instead of All at Once

The Problem With a Single Repayment Date

A conventional bond pays interest periodically and the entire principal at maturity. That final payment called bullet the entire loan arrives at once

For an issuer this is a refinancing event of substantial size. If the credit markets are closed on that date or the issuer's credit has deteriorated payment must be made with cash that the company does not have. Maturity walls concentrate risk on specific dates for reasons that have nothing to do with the business

a sinking fund The provision addresses this by requiring the issuer to withdraw a portion of the issue each year for a defined period before maturity

The underlying observation is that a bullet quietly contains a bet that no one negotiated. Signing a bullet is agreeing to borrow the money again at a date years from now on unknown terms from lenders who have not committed to anything. Business risk in borrowing is one thing. The risk of the credit market closing on a particular Tuesday is another and a sinking fund is the mechanism for not taking it all at once

How the Requirement Is Satisfied

The contract specifies an annual amount and the issuer generally has options on how to meet it

The first two rows are the important ones because they create an option that belongs to the issuer

When the bond is trading above par usually because interest rates have fallen the issuer calls the bonds at par through a lottery among holders. Selected holders receive one hundred cents for a bond that is worth more and lose the market coupon mentioned above

When the bond is trading below par the issuer buys into the market at a discount meeting the requirement at a price lower than the face amount

In both cases the issuer takes the favorable path meaning that the holder is always on the wrong side of the choice

The Lottery Is the Part That Surprises People

That notice describes something genuinely unusual and it is worth making clear what it means for an individual holder and not for the issue as a whole

Most bond risks apply evenly. If rates change all holders of the same bond experience the same price change. If the issuer's rating is downgraded everyone who owns the paper is affected in the same proportion

A sinking fund call does not work that way. The issuer must withdraw a defined portion of the issue and identify which specific bonds to call by lottery. Therefore two investors holding identical positions in the same bond can have completely different results in the same year. One has bonds redeemed at par and loses an above-market coupon. The other keeps the position intact

Exposure is also unequal depending on size. A large institutional holder holding a large portion of the issue will have approximately the average proportion claimed so the lottery does what a large sample does and the result is close to what is expected. A small holder is exposed to the true draw. A position can be completely redeemed in a single year or survive intact until maturity and the difference is chance

There is no way around it. The holder cannot opt ​​out cannot choose to be excluded and cannot hedge an event whose timing is a random selection between identical instruments. It is an idiosyncratic risk in an asset class where almost nothing else is idiosyncratic which is why it traps people who are used to bonds behaving in predictable ways

What the Holder Gets in Return

Against all that is the protection that the provision was drafted to provide and it is worth setting it out properly rather than leaving it as a statement because it works in two different ways

The first is decreasing exposure. In the case of a bullet the entire principal remains at risk until the last day so a credit that deteriorates in the eighteenth year threatens the entire amount. Under a repayment schedule most of the principal has already been repaid by then and only the rest is exposed to whatever the issuer has become. The investor's position is reduced as the forecast horizon lengthens which is the correct direction for uncertainty to develop

The second is an earlier warning and is the more useful of the two. A sinking fund payment is a mandatory obligation and failure to do so is an event of default in its own right. This gives creditors a live test of the issuer's ability each year rather than a test at the end

Therefore an issuer that is going to be in trouble reveals it on a schedule. Instead of appearing healthy for nineteen years and failing to refinance it visibly struggles with a payment it has to make now while there is still time for creditors to act and for the business to restructure and have some time left to restructure

What It Does to the Bond

Mandatory partial retirement has several consequences

The average lifespan is shorter than maturity. A bond maturing in twenty years with a sinking fund beginning in year ten has an average life of well less than twenty years and should be valued on that basis and not the stated maturity. Comparing the returns between a sinking fund bond and a bullet bond of the same stated maturity compares different instruments

The duration is shorter meaning less sensitivity of prices to changes in interest rates reducing both the loss when rates rise and the profit when they fall

Reinvestment risk is higher because the holder receives the capital periodically and must redistribute it at the rates that exist at that time

Liquidity decreases over time since the amount in circulation reduces each year and a smaller issue trades worse

Working Out the Average Life

The first of these is the one that changes the way the bond should be priced so it is worth calculating it rather than stating it. The following figures are illustrative and round

Take as an example the twenty-year bond described above with a sinking fund that withdraws an equal amount each year from year ten until maturity in year twenty. These are eleven equal retirements so approximately nine percent of the issue returns each year in that tranche

The average life is the average time until one dollar of principal is paid weighting each payment by the amount that arrives. With equal amounts in years ten through twenty the average of those years is fifteen

Thus an instrument sold as a twenty-year bond returns its principal on average in year fifteen. That is a five-year difference and it changes the answer to almost every question an investor asks about the bond

The comparison problem immediately follows. Pricing this bond against a twenty-year bullet puts a fifteen-year average life next to a twenty-year average and considers them comparable. On any upward-sloping yield curve the bullet should yield more simply by being longer so a naive comparison makes the sinking fund bond look expensive when it is a shorter instrument that is priced correctly

The same logic applies to duration and reinvestment. A holder who receives capital in eleven installments starting in year ten is in a materially different position from one who waits until year twenty and all the differences can be traced back to this single number

The Accelerated Option

Many contracts include a duplicate option allowing the issuer to withdraw up to twice the required amount in a given year

This is an additional call feature and is exercised for the same reason any call option is exercised: when it is favorable to the issuer that is when rates have fallen and bonds are trading above par. It compounds the disadvantage for holders in a falling interest rate environment and its price should be valued for what it is: a built-in option written by the investor

Where They Are Still Common

Sinking funds were once standard in corporate bonds and have become much less common in that market largely because issuers don't like the mandatory cash requirement and investors in liquid corporate markets found the credit protection less valuable than the flexibility they gave up

They remain widespread in municipal bonds particularly in serial and term bond structures where scheduled mandatory repayments are the norm. They also appear in project financing and in preferred shares where the underlying logic is stronger: an entity whose cash flows are finite such as a toll road concession or resources project should amortize its debt over the life of the asset rather than assuming it can refinance a bullet against an asset that is nearly depleted

Why a Finite Asset Cannot Carry a Bullet

That last point is the strongest version of the entire argument and it deserves analysis because it explains why the supply faded in one market and persisted in another

A corporate issuer is supposed to continue indefinitely. When its bonds mature it hopes to refinance a business that will still be generating cash twenty years from now. The bullet works because there is something to lend against on the other end

A finite-lived asset offers no such thing. A concession has a defined duration and then the asset returns to the grantor. A mine runs out. A power purchase agreement expires. Cash flows not only become uncertain they stop according to a schedule known from the beginning

Now put a bullet in that. Principal comes due near the end of the asset's productive life and the borrower has to persuade a lender to advance the full amount against an asset that has only a few years of cash flows left. No lender does that sensibly because there isn't enough life left to repay a new loan

Therefore the refinancing that a corporate bullet takes for granted is not only risky in project financing. It is almost impossible by construction and the borrower depends on it precisely when the asset is least able to support it

Amortization eliminates the problem rather than managing it. Repaying the principal in line with the cash the asset actually produces means that the debt reaches zero around the time the asset does and no refinancing is required. The structure matches the liability with the thing that pays it which is the general idea

If you read the corporate market's withdrawal from sinking funds from that perspective it seems more coherent than careless. Going concern issuers gave up protection against a risk that they actually face less of in exchange for flexibility that they value. Issuers that finance assets with an end date kept it because for them risk is not a possibility it is a certainty on a date that is already in the contract

How to Evaluate One

The practical analysis is brief. Determine the sinking fund schedule and calculate the average life instead of using the stated maturity. Check to see if the issuer can meet the requirement through open market purchases which is favorable to the issuer in weak markets. Look for a doubling option. And when the bond is trading above par recognize that the sinking fund is functionally a partial call option and price accordingly because the yield to maturity quoted on a bond that will retire partially at par is not the yield you will receive

The Bottom Line

A sinking fund replaces a large repayment with a series of smaller payments which actually reduces the risk that an issuer will be unable to refinance and is why the provision exists. The cost to the holder is that all discretion over how the requirement is met belongs to the issuer and is exercised against you in both directions by the issuer. Evaluate the bond based on its average life rather than its maturity and treat any bond trading above par with an active sinking fund as a partially instrument.bailed out because that's what it is. When the borrower is an asset with a maturity date and not a company the provision stops being a concession to investors and becomes the only structure that makes sense