Sinking fund

Hi, Can someone explain the line below to me?I don’t quite get the point of it of the entire thing…I have borrowed money from X so I lend to Y and keep the receipt with Z? Delivery of securities. The issuer may purchase bonds with a total par value equal to the amount that is to be retired in that year in the market and deliver them to the trustee who will retire them.

it is not that important. just know that sinking funds benefit the investors most of the time, as they get to sleep better @ night knowing the debt will be retired in an orderly fashion. looks like you are doing fixed income you guys have time left, but if you are tight on time, focus on forward rates, bootstrapping, and of course, duration/convexity.

The trustee is the person responsible for making sure that the bond issuer complies with the sinking fund provisions. Suppose the provisions say that the issuer will call 10% of the 2000 bonds in 2008. The issuer can go out into the market place, buy 200 bonds, and deliver them to the trustee. The trustee will then “retire” the bonds (think paper shredder) and that will constitute compliance with the sinking fund provisions.

Thanx daj/JDV… JDV-Would it be right in assuming that the issuer buys back the bonds he’s issued?Or does he buy completely new bonds with same maturity/coupon/yield?

The sinking fund is part of the terms of a particular issue of bonds. You have to buy back those bonds because the sinking fund is about retiring principal on that issue of bonds as a kind of credit enhancement. Sinking fund provisions are serious things; if you don’t comply with the sinking fund, you have defaulted on the bond just as if you didn’t pay people interest owed.

More on sinking funds: Just to add, many sinking fund provisions allow the issuer two options to obtain the bonds to retire: 1.) Purchase the bonds in the secondary market. 1) A par call option for up to the amount of the sink on the date of the sink This benefits the issuer, as they have the option to buy the bonds in the secondary market (if bonds are trading at a discount) or they can call them at par based on a random lottery. This adds uncertainty to holders of the bonds as they can have their securities called at a sinking fund date. Bonds with sinking fund provisions exhibit negative convexity as rates fall.

This negatively affects bondholders who hold bonds trading at a premium as the sinking fund provision can cause the bonds to be “called” at par, realizing a loss for the bondholder. Right?

Yes. That sucks when it happens.

Its something to be careful of, as the default pricing ie on bloomberg, prices the bonds to “average life”, even though you could theortically have all of your bonds called at any of the sink dates