How do sinking fund structure retain the upside potential during interest rate decline ???
Isn’t this LII stuff?
NO , this is very much a L3 stuff as it has been discussed in the rationale for trading … I am more interested in the rationale for sinking fund as i am not very clear ???
I dunno. All I know is that: When interest rates decrease, then the values are as follows: Sinking Funds < Callables < Putables < Vanilla Bonds When interest rates increase, then the values are as follows: Sinking Funds > Callables > Putables > Vanilla Bonds Can someone explain how a sinking fund works? Does a sinking fund’s notional value decrease over time?
Issuer has an obligation to retire part of the obligation, sequentially and prior to maturity. Think of it like a call, except there’s a legal defeasance (I believe). Because the market bakes in this feature into the pricing, they tend to not decline as much as bonds without this feature in rising rate climates (since essentially the duration’s reduced by the issuer’s obligation). Sinking Fund structures were popular when most of you were in diapers (mid-late '80s). They are rare now for new issues - I’m not aware of any (work in corporate debt mkts). So, if the CFA asks about Sinking Funds next Saturday it will prove they are completely out of touch (my opinion).
Why would this be the order when rates increase? When interest rates increase, then the values are as follows: Sinking Funds > Callables > Putables > Vanilla Bonds If rates increases, in my opinion, the negative delta in value in %, would be highest for: 1 - Vanilla, 2 - Callable, (Value of Call Option goes down) 3 - Putable, (Value of Put Option goes up, negative delta % capped at put price) 4 - Sinking Funds. (% of Notional refunded for you to invest at higher rates)
Anyone have a LOS or Page reference? I don’t remember sinking fund in my notecards.
Sure, it’s RVM, LOS 29(e)… Structural Analysis
basic interest rates decrease, prices increase. in a sinkable, instead of the whole thing getting called away, a portion of it get sunk (if that’s the way to say it)/retired periodically. so you as an investor still have most of your bond and would get some upside potential (less so than no sinkable feature). on the plus side of a sinkable, instead of you having lots o risk at maturity, since periodically this thing has been retired, it downs your risk at maturity since it’s not the full principal you should be getting back. think of it maybe like only a partial call if you want? bidder, are your things right up there? i want to say no. When interest rates increase, then the values are as follows- Putables > Sinking Funds > Callables > Vanilla Bonds
Bannisja Im pretty sure I am right on the returns relationships You can re-read the curriculum to double check VinceMTL, when rates increase, bond values decrease, so there is no way that a vanilla bond will have the highest value out of those 4 securities
bannisja, good summary.
Just to check, CFAI says ‘These discounted sinking funds retained price upside during interest rate rallies’, while Schweser says ‘sinking fund structure retain the upside potential during interest rate decline ???’ as mentioned in the opening post.
Which is correct? (Definitely CFAI but why?) Thanks much.
From Schweser…please read the notes carefully because you’re missing a key word, DISCOUNT.
“Sinking funds. Sinking funds provide for the early retirement of a portion of an issue of bonds. Sinking fund structures priced at a DISCOUNT to par have historically retained upside price potential during interest rate declines as long as the bonds REMAIN PRICED AT A DISCOUNT TO PAR (the firm can call the bonds back at par). Furthermore, given that the issuer is usually required to repurchase part of the issue each year, the price of sinking fund structures does not fall as much relative to callable and bullet structures when interest rates rise.”
Or at the least do the work and paste in the quote from the notes so we can read it word for word and not take your interpretation of it as god.