Debt covenants t o protect bondholders are leas t likely to : A . restrict the payment of dividends . B . require sinking fund redemptions. C . prohibit bond repurchases at a premium to par. I thought sinking funds are bad for bondholders because they give your money early using lottery… The answer is C Would someone please explain ??
If I understand the qn correctly, which it’s taking me some time to do (I think I’m getting really tired).
C is like the greater of the 2 evils, so to speak. Least likely to prohibit premium to par. If you want to protect bondholders, I guess that you don’t want a covenent that would prohibit a redemption at premium to par?
A sinking fund protects bondholders because it reduces the risk that the issuer will default; it’s easier (less risky) to raise $1,000,000 each year for 10 years than to raise $10,000,000 in one year.
Assuming that those covenants are placed to improve company’s liquidity and solvency, anything that improves it in fact is in the interest of bondholders. That is at least as I see it.
Repurchases at premium to par is in the interest of the bondholders, hence debt covenants (which are provided to protect bondholders) are LEAST LIKELY to PROHIBIT something that could benefit bondholders. I think it’s just the wording of choice C that makes it tricky.
Okay, so a sinking fund provision is where the bond issuer MUST pay off some of the principal each year in addition to the interest payments.
What’s the difference between this and with MBS where the home-owners can choose if/when they want to make additional pre-payments depending on favorable environments for them to do so? Or is that just inherent in MBS’s? Because in the reading it made it seems as though it was clearly a bad thing for the MBS holder because of pre-payment risk.
I’m wondering why that doesn’t apply to sinking fund provisions? Is it because the pre-payment is formalized and the bond holders know exactly what they’re getting into and can time all of the cashflows, so an increase in liquidity is only a good thing?
A sinking fund is certain; prepayments are uncertain.
However, who gets paid in a sinking fund can be uncertain; if the bonds are selling above par, those paid off are selected by lottery. Yours may be chosen, and they may not be.