What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
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Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and co-directors of the company’s pension fund management division. An important new client, the North-Western Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. |
Explanation
A call provision is a provision that allows the issuer to repay the bond before the maturity date. It is only an option for the issuer and not an obligation.
A call provision is beneficial to the issuer in case of falling interest rates. In that case, the issuer will call the bonds and re-issue the new bonds at a lower interest rate. However, it makes the bonds risky for the investors and thus, they require more interest on callable bonds. Normally, the call price is more than the face value of the bond, to compensate the investor for the additional risk, which is taken by them.
A sinking fund provision facilitates a company in the orderly retirement of the bond issue. It also protects bondholders by ensuring that an issue is retired in an orderly fashion.
However, a sinking fund can prove to be disadvantageous to the bondholders as well, if the interest rates fall after issuance.
On the whole, the bonds that have a sinking fund are regarded as being safer than those without such a provision, so at the time they are issued, sinking fund bonds have lower coupon rates, than otherwise of similar bonds without sinking fund provisions.
Verified Answer
A call provision is a clause in the bond agreement which allows the issuer to retire the bond before maturity date. It is beneficial for the issuer and risky for the investors.
A sinking fund provision facilitates a company in the orderly retirement of the bond issue. It protects bondholders by ensuring that an issue is retired in an orderly fashion and thus, makes the bonds with sinking fund provision comparatively safer, than those bonds which do not have this provision.
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