The Differential Effects of Sinking Funds on Bond Risk Premia

Abstract

This study analyzes the effect that two options created by the inclusion of a sinking fund clause in a bond indenture have on the bond issue's secondary market risk premium. The impact of market prices that exceed current sinking fund redemption prices, and of par versus premium redemption, is clearly apparent when a set of issue-specific and macroeconomic control variables are incorporated into a model of bond risk premia. Thus. secondary market prices for the large-volume utility bond transactions in the sample reflect knowledge of individual-issue. time-varying indenture characteristics.*University of Miami. The authors wish to thank the anonymous referees for their constructive comments. Responsibility for any errors rests with the authors. 303

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

“…On October 4, 1979, the Federal Reserve Board announced that monetary policy would focus on monetary aggregates, with consideration of interest rates relegated to second place. A significant effect of this policy change on bond risk premia is demonstrated by Barrett, Heuson, and Kolb [1] and a significant effect on Treasury bond option premia is shown by Jordan, Seale, and Barnhill [12]. The same policy change is examined in the present study and is shown to have a significant impact on sinking fund preferred stock.…”

“…Barrett, Heuson, and Kolb [1] cite additional factors impacting the sinking fund effect. They examine three test variables: (1) the intrinsic value of the option to call for the sinking fund requirement at par or market; (2) the striking price effect of ability to call at par or above par; and (3) the effective maturity. Their study includes a variable to control for the effect of a change in monetary policy.…”

“…If the sinking fund effect changes from month to month, then observation of changes in this effect must be made month to month. The following model represents a relationship between sinking fund and non-sinking fund preferred that changes continuously over time: (1) where R st is the return on a portfolio of SFP stock for month t, R nt is the contemporaneous return on a portfolio of NSFP stock, A is the intercept of this relationship, and B is the slope coefficient of this relationship. The subscript on the intercept and slope indicates that the parameters are specific to a particular month.…”

“…Changes in A and B from one month to another indicate a change in the relationship between returns on SFP and returns on NSFP. Examining changes in intercept or slope of equation (1) allows an event analysis to be performed on any month or group of months during six years. The result is essentially an event study in which the event date or dates are not specified in advance.…”

“…The model expressed in equation (1) must necessarily be sparse because its coefficients are re-estimated from every monthly observation in the sample period. A more complex model might allow identification of specific factors affecting the relationship but would be more difficult for identifying the timing of any change.…”