Investments, tenth edition

14.8 

  Bond Indentures 

 A bond is issued with an  indenture,  which is the contract between the issuer and the bond-

holder. Part of the indenture is a set of restrictions that protect the rights of the bondholders. 

Such restrictions include provisions relating to collateral, sinking funds, dividend policy, 

and further borrowing. The issuing firm agrees to these  protective covenants  in order to 

market its bonds to investors concerned about the safety of the bond issue. 

  Sinking Funds   

Bonds call for the payment of par value at the end of the bond’s life. 

This payment constitutes a large cash commitment for the issuer. To help ensure the com-

mitment does not create a cash flow crisis, the firm agrees to establish a    sinking  fund     to 

spread the payment burden over several years. The fund may operate in one of two ways:

    1.   The firm may repurchase a fraction of the outstanding bonds in the open market 

each year.  

   2.   The firm may purchase a fraction of the outstanding bonds at a special call price 

associated with the sinking fund provision. The firm has an option to purchase the 

bonds at either the market price or the sinking fund price, whichever is lower. To 

allocate the burden of the sinking fund call fairly among bondholders, the bonds 

chosen for the call are selected at random based on serial number.  

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 The sinking fund call differs from a conventional bond call in two important ways. 

First, the firm can repurchase only a limited fraction of the bond issue at the sinking fund 

call price. At best, some indentures allow firms to use a  doubling option,  which allows 

repurchase of double the required number of bonds at the sinking fund call price. Second, 

while callable bonds generally have call prices above par value, the sinking fund call price 

usually is set at the bond’s par value. 

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  Bond Prices and Yields

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 Although sinking funds ostensibly protect bondholders by making principal repayment 

more likely, they can hurt the investor. The firm will choose to buy back discount bonds 

(selling below par) at market price, while exercising its option to buy back premium bonds 

(selling above par) at par. Therefore, if interest rates fall and bond prices rise, firms will 

benefit from the sinking fund provision that enables them to repurchase their bonds at 

below-market prices. In these circumstances, the firm’s gain is the bondholder’s loss. 

 One bond issue that does not require a sinking fund is a  serial bond  issue, in which the 

firm sells bonds with staggered maturity dates. As bonds mature sequentially, the principal 

repayment burden for the firm is spread over time, just as it is with a sinking fund. One 

advantage of serial bonds over sinking fund issues is that there is no uncertainty introduced 

by the possibility that a particular bond will be called for the sinking fund. The disadvan-

tage of serial bonds, however, is that bonds of different maturity dates are not interchange-

able, which reduces the liquidity of the issue.