Sinking Funds and the Cost of Corporate Debt

Abstract

TWO MAJOR REASONS GENERALLY are cited for including sinking fund provisions in corporate bond issues. First, they reduce default risk by providing for an orderly debt service pattern that systematically reduces the principal outstanding. Second, purchases for the sinking fund help provide a liquid market for the bond issue (see [2]). This reasoning suggests that the yield required by investors-and, therefore, the issuer's interest costs-will be lower for debt obligations that carry sinking fund requirements than for those that do not. In their analysis of sinking funds and investor realized yields, Jen and Wert [4] demonstrate that lower yields on bond issues with sinking funds can be explained by the term structure of interest rates. They also point out that this yield effect results in a reduced interest rate to the issuer.The apparent benefits of sinking fund provisions notwithstanding, the incidence of such bonds varies according to the type of issuer. In particular, public utility and finance company obligations often are issued without sinking fund provisions, whereas industrials almost invariably include sinking fund requirements (see [2]). The type, amount, and timing of sinking fund requirements also varies.' This paper examines the effect of sinking funds on the interest cost for a given bond issue and on an issuing firm's total costs in maintaining a given level of debt financing. I. Sinking Fund Provisions and Interest RatesIn this section we examine reoffering yields on new bond issues, comparing sinking fund bonds to bonds without sinking funds. For the purpose of this study, a sinking fund bond is defined as one that provides for the retirement of between 75 per cent and 100 per cent of the initial principal amount of the issue before maturity, whereas a nonsinking fund issue is defined as one where the sinking fund (if any) retires less than 25 per cent of the initial principal before maturity. Methodology. Industrial and public utility new issues during a seventeen-year period, from 1960 through 1976, were examined. Sinking fund and nonsinking * University of Wyoming and University of Tulsa, respectively. We are grateful to Steve K. Burke for his assistance, and to Stanley A. Martin, Jr., and Richard A. Robrock for their comments.' There are many different types of sinking funds: the size of the sinking fund can be a percentage of a given issue or of total debt outstanding; it can be fixed or variable; and it can be stated in either a dollar or a percentage basis. In some cases, sinking fund contributions can even be used to purchase additional fixed assets rather than to reduce debt. The amount of the issue that must be repaid before maturity may range from a nominal sum to 100 per cent; and the payments may commence at the end of the first year or may be deferred for 5 to 10 years from the date of issue. This latter practice is common during periods of high interest rates. (See [3] pp. 218-222 for additional details concerning sinking fund provisions.) 887

The Independent Impact of Credit Rating Changes – The Case of Moody's Rating Refinement on Yield Premiums

“…Sinking fund provisions tend to reduce a bond issue's risk because the provision ensures orderly retirement of bond issues (Boardman and McEnally, 1981;and Dyl and Joehnk, 1979). So the sign of the coefficient of sinking fund (SINK) is expected to be negative.…”

“…For example,Dyl and Joehnk (1979) find that the effect of sinking fund provision is less important for higher-grade bonds than for medium-grade issues. Similarly, the impact of maturity on yield premium may not be uniform across rating categories due to the`crisis at maturity' phenomena as noted byJohnson (1967).…”

Sinking Funds and the Agency Costs of Corporate Debt

“…The binary choice model of sinking fund provisions in (1) is formulated based on an approach similar to that of Dyl and Joehnk [6]. In their study, analyses were performed by separating the bond issues with sinking funds from the issues without sinking funds, and the differences between both types of bonds were analyzed.…”

“…In fulfilling this obligation, the firm has an option to either purchase the bonds at market or call the bonds on a lottery basis at a predetermined exercise price. The widespread use of sinking funds has prompted much theoretical and empirical investigation (see [5,6,9,101).…”

Valuation of the Preferred Stock Sinking Fund Feature: A Time‐series Approach

“…Dyl and Joehnk [5], Boardman and McEnally [4], Lloyd and Edmonds [15], and Jen and Wert [11] study the effect of a sinking fund on bond yields. Results of the studies differ on the sign and size of the sinking fund effect.…”