CFA Level 1 : Difference between Prepayment option, Call provision and Sinking fund provision ?

CFA Level I
#1

Folks,

I’m bit confused between these terms :-

  1. Prepayment Option

  2. Call provision

  3. Sinking fund provision.

Do they all apply only to principal repayment ? Or Interest payment also ?

What is the difference between these terms ? Explaination with example would be appreciated.

#2

Hey Thurst,

I am also just a L1 candidate so I am going to try my best to answer your question but maybe someone else can chime in on anything I am mistaken about.

I believe all three of the terms deal with the repayment of principal, which in turn means the interest payments will cease. Here is how I view each of the terms:

  1. Prepayment Options : Deal solely with amortizing securities (like MBS) and occurs if borrowers (homeowners) refinance, sell their home, default, or simply pay off their mortgage early. The investors will receive the principal portion and will no longer continue to receive the interest cash flows. This can be a problem because homeowners will typically refinance when interest rates are low so the investors will be left with a large sum of money and no place to invest it.

  2. Call Provision : These deal with non-amortizing securities and give the borrower (company, gov’t, ect) the right to buy back the bond at a predetermined price and therefore the interest payments stop. These can be thought of in a similar fashion as the prepayment option but in regards to non-amortizing securities. The borrower will typically call back the bond if rates drop so that they can replace it with a lower coupon issue. Again the investor suffers here because they receive a large sum of money and no place to invest it.

  3. Sinking Fund Provision : Provides the issuer the ability to repay a portion of the bond issue annually as opposed to repaying the entire issue at maturity. This is very similar to the call provision but requires the issuer to retire a certain amount of the total issue every year whereas the call provision just grants them the right but not the obligation. This provision also benefits the investors because it is assumed that the issuer is less likely to default on the repayment of the remaining principal at maturity since the amount is substantially less than it would be without the provision.

Please note that I took a majority of this information from the Schweser materials and Investopedia.

#3

I believe a refund is more absolute than Call. i.e, you may or may not get a call.

#4

Well said.

Just a couple of other observations:

A prepayment option is just that: an option, owned by the issuer of the bond (the borrower). They can exercise it if they wish (generally when it’s favorable to them), but they don’t have to. If exercised, the prepayment is usually made at par. (Some mortgages have prepayment penalties, but I’ve never seen those stressed on the Level I CFA exam; I wouldn’t worry about them: assume prepayments are at par.)

A call option is just that: an option, owned by the borrower. They can exercise it if they wish (when it’s favorable to them), but they don’t have to. If exercised, the bond is usually called at a premium above par; it will be clear in a problem if that’s the case (e.g., callable after 5 years at 103: the borrower would have to call a $1,000 bond at $1,030 (plus accrued interest)).

A sinking fund provision is not an option; it’s an _ obligation _ of the borrower to repurchase a given fraction of the original bond issue in a given year. The provision is usually at par, but if the bonds are selling at a discount on the open market, they’ll buy them at market price and save some money. If the bonds are selling at a premium, they’ll choose the bonds to retire by lottery, so any individual bondholder may have none, some, or all of his bonds purchased and retired; the bondholder has no choice in the matter.

#5

This was just the thread I was looking for! I was going to post this a few days again because I didn’t know the difference between a prepayment and sinking fund but I forgot.

Is it correct to say that prepayment option and put options favour the investor, and sinking fund and call option favour the issuer?

#6

No.

Prepayment options and call options favor the issuer. They can pay off the bond early when interest rates are low and refinance at lower rates.

Put options favor the investor. They can put the bond when interest rates are high, and reinvest at higher rates.

A sinking fund provision might be good or bad for the issuer and the investor. It requires that the issuer pay off a portion of the bonds early, whether rates are higher or lower. But if rates are higher at least the issuer can buy the bonds at less than par in the market. By requiring the issuer to pay off some of the bonds early, it may reduce the risk of default to the investors (it may be easier for the issuer to get an extra $1 million each year for ten years than to get an extra $10 million in year 10), but if interest rates are low the investor may be forced to sell his bond at par when the market price is above par.