A sinking fund provision in a bond contract requires the issuing company to retire a portion bond issue each year. Select one:
True
False
The correct answer and explanation is:
Correct Answer: ✅ True
Explanation (300 words):
A sinking fund provision in a bond contract is a feature that requires the issuing company to retire (repay) a portion of the bond issue periodically, typically on an annual basis, before the final maturity date of the bond. This provision is designed to protect investors by ensuring that the issuer gradually sets aside money to repay the bond principal, reducing the risk of default at maturity.
Under a sinking fund provision, the issuer might make annual payments into a sinking fund, which is then used to repurchase bonds in the open market or call (redeem) them directly from bondholders. The bonds retired through the sinking fund can be selected randomly, by lottery, or on a pro-rata basis.
From the issuer’s perspective, a sinking fund can make the bond more attractive to investors, allowing the company to issue debt at a lower interest rate, since the risk to bondholders is mitigated. It also spreads out the repayment burden over several years, improving the company’s cash flow management.
For investors, a sinking fund reduces credit risk because the issuer shows a commitment to repaying the debt over time. However, it can also be a disadvantage if interest rates decline, because the bonds might be called back earlier at par value when their market price is higher—resulting in lost interest income or capital gains.
In summary, a sinking fund provision does require the issuing company to retire part of the bond issue each year (or at set intervals), which makes the correct answer to the question True. This mechanism provides a structured way for debt repayment and adds a layer of security for bondholders, while potentially offering cost benefits to the issuer.