CFA Level IFixed IncomeEasy
A corporate bond indenture includes a sinking fund provision requiring the issuer to retire a portion of the principal each year prior to maturity. Relative to an otherwise identical bond without this provision, the sinking fund provision most likely:
- AIncreases the bondholder's reinvestment risk only, with no effect on credit risk
- BSubstantially increases the bond's effective duration relative to a bullet maturity bond
- CReduces credit risk to bondholders by lowering the amount of principal outstanding at final maturity
- DEliminates the bond's exposure to interest rate risk entirely
Show answer & explanationAnswer & explanation
Correct answer: C. Reduces credit risk to bondholders by lowering the amount of principal outstanding at final maturity
A sinking fund requires periodic retirement of principal, which reduces the amount of debt outstanding at maturity and thus lowers the issuer's default risk exposure to bondholders as a class, though it may increase call/reinvestment risk for individual bondholders whose bonds are called.
Why the other options are wrong
- A. Ignores the credit risk reduction effect, which is the primary benefit of sinking funds.
- B. Sinking funds shorten average life and typically reduce, not increase, effective duration.
- D. Sinking funds do not eliminate interest rate risk; the bond still has a duration.
Sinking Fund Provision
A bond indenture clause requiring the issuer to retire a specified portion of the bond issue periodically before maturity, reducing the amount outstanding at final maturity.
- Reduces credit risk to bondholders as a class
- Increases call/reinvestment risk for individual bondholders
- Shortens the bond's average life and duration
Memory trick: Sink the debt, shrink the risk.