Hi, could you tell me the differences between Callable Bonds and Refundable Bonds in plain English? As regards the sinking fund provision, it mentioned one of the retiring methods is to make a cash payment to the trustee equal to the par value of the bonds to be retired; the trustee then calls the bonds for redemption using a lottery. etc. Does this mean whoever hit the lottery and be called for redemption is at a disadvantage? Thx.
Callable Bonds - A bond is callable if the issuing company can redeem the shares before the maturity date. For example, you bought a 10 year bond from XYZ company. XYZ can call the bond after 5 years at 101. This means after 5 years, XYZ can force you to give up your bond, but they’ll pay you 101% of par value. What are the disadvantages to the purhcaser? He/she has to give up the bond and will not be able to collect the coupons anymore. The principal is returned which exposes this bondholder to reinvestment risk. Why would a company want to do this? If market interest rates have decreased to the point where XYZ can issue new bonds that pay a lower coupon, it will be worth it for XYZ to call the existing, higher coupon-bearing bonds to issue new, lower coupon bonds. The interest payments will then be lower for XYZ. Refundable Bonds - If a bond is refundable, XYZ can call your bonds and pay them off using the proceeds from a lower-coupon issue (the situation described above). If a bond is non-refundable, then XYZ can’t use the proceeds from a lower-coupon issue to do this. But, a bond can be both callable and non-refundable. In this case, XYZ would call your bonds, but they can’t pay off the principal with the proceeds from another lower-coupon issue. They can, for example, pay it off instead with straight cash from a general account. I’m not sure if this is plain English. And yes, whoever is randomly chosen to be paid off sooner through a sinking fund provision is at a disadvantage assuming they wanted to hold onto the bonds. It’s similar to your bond being called. You are forced to redeem your bond.
I’m not sure that the sinking fund provision necessarily disadvantages the bondholder - it’s not a random call because a bond call is an option that accrues to the issuer. The issuer decides when to call the bond based on his cash position, market value of the bonds, interest rates, etc… The sinking fund provision is credit protection on the bond. The issuer must make sinking fund payments or he is in default. The bond could be selling at 80 (theoretically) and you could get a sinking fund call at par. Maybe the sinking fund is equally likely to be a call accruing to the issuer as a put accruing to the bond holder… Edit: Topher did a really good job of answering the other parts as befits a newly minted LII candidate. Edit 2: typo
Professor Joey, thank you for the clarification.
Thx. I think it’s explained very well for me, especially the refundable bonds part. Sometimes the book statements could be long; converluted and arcane… Well, good to know the details. Do you think the bond with the sinking fund provision might be beneficial for both bond issuer and bondholder? In general, the bond with this provision should have lower risk than the one without for investors. And from the perspetive of bond issuers, it lowers their potential exposure to credit risk, correct? But somehow I felt it favors more to bond issuers than to bondholders. What if an investor got a fantastic deal at issuance day and then after 5 years by accident hit lotto and had to redeem the bond prior to the maturity date? In that case, his good deal was terminated prematurely and he’ll have to face reinvestment risk. Isn’t it considered a loss?
Is sinking/accelerated sinking fund provision similar to prepayment provision? If so, why they are listed as two separate grants to bond issuers? If not, what’s the main difference btwn the two? The book gave me the impression that when issuer exercises the sinking fund provision, the issue is redeemed at par. Is this always the case? I think whether investor gain or lose when called to redeem @par depends on whether he/she initially purchased the issue @discount or @premium. In addition, if the sinking fund provision specified the time horizon to retire a specific amount of the bond evenly per year till maturity, can the issuer exercise this option before the specified time? Assume it’s $200M; 7.5% coupon 20 year bond issued at Jan. 1, 2000 and the sinking fund provision requires it retire $8M per year from 2010 till maturity. Can the issuer exersice this option at year 2008?
Accelerated sinking fund and sinking fund are different. Accelerated is an option for the issuer that allows them to call some or all of the bonds. It’s really just a call on a sinking fund bond. "In addition, if the sinking fund provision specified the time horizon to retire a specific amount of the bond evenly per year till maturity, can the issuer exercise this option before the specified time? " That would be an accelerated sinking fund and he can only do it if that’s part of the indenture. A sinking fund is not an option. "The book gave me the impression that when issuer exercises the sinking fund provision, the issue is redeemed at par. Is this always the case? " Hmm… Always is a big word, but a sinking fund is about retiring the debt principal so it would be a little odd to retire debt principal by paying 101 or something. But, again, the issuer doesn’t “exercise” the sinking fund provision; he complies with the terms of the bond which require that he satisfy the sinking fund provision or he is in default, gets sued, all the CDS buyers need to get paid, etc…
Thx, Joey. Regarding your comments, I checked again. According to the book, accelerated sinking fund provision is the one that grants the issuer to retire MORE than the sinking fund requirement. So my understanding of the acceleration here is: it’s more about the retiring amount than the time. Also the provision is an embedded option which means it’s the kind of option that could be traded on an exchange or at OTC market. That’s why I used the word of “exercise”. Sure, this could be confusing. I may better use “implement” instead. So my question is: if a time horizon is specified for the sinking fund provision, is it a violation for the issuer to start using this embedded option before that time period? And how do you consider this with prepayment provision?
hyang Wrote: ------------------------------------------------------- > Thx, Joey. > > Regarding your comments, I checked again. > According to the book, accelerated sinking fund > provision is the one that grants the issuer to > retire MORE than the sinking fund requirement. Yes - they are calling bonds that the sinking fund does not require them to call. They would do this because, say, interest rates went down. > So > my understanding of the acceleration here is: it’s > more about the retiring amount than the time. Well, okay, but eventually all bonds get retired. > Also > the provision is an embedded option which means > it’s the kind of option that could be traded on an > exchange or at OTC market. Nope - You can’t directly trade an accelerated sinking fund provision just like you can’t directly trade an embedded bond call. You could monetize it in the swaptions market which is a LIII (I think) topic. The “embedded” means it is an option that can’t be traded separately from the bond. > That’s why I used the > word of “exercise”. Sure, this could be confusing. > I may better use “implement” instead. > > So my question is: if a time horizon is specified > for the sinking fund provision, is it a violation > for the issuer to start using this embedded option > before that time period? > The sinking fund is not an option and he can’t retire more bonds than the sinking fund allows (an accelerated sinking fund provision might let him retire all the bonds). If someone sent out letters to the owners of all the bonds that they were getting a sinking fund call even though the sinking fund provision allowed for just 10% this would be fraud. Since it would usually be done by a trustee there would probably be conspiracy going along with it. People would go to jail. > And how do you consider this with prepayment > provision? A sinking fund is something like a mortgage that you couldn’t prepay. You must make defined principal payments and are in default if you dont. An accelerated sinking fund is like a typical mortgage that you can prepay principal whenever you want (though the accelerated clause probably wouldn’t be that good).
Sorry, I meant to say it’s an embedded option, NOT the kind we traded at the exchanges. Yes, I do understand this. So in a sense, you’re saying an accelerated sinking fund is like a typical mortgage and it’s equivalent to prepayment provision. The borrower can decide how much to pay… I remember I prepaid my student loan in less than 3 years although it’s scheduled for 10 years. I did not get punishment for prepayment. Is this also something comparable?
Right, except that your student loan is pretty sweet deal and an accelerated sinking fund is probably not going to let the issuer prepay as many bonds as he wants whenever he wants.