The strategies implicit in the structure of sinking fund bonds and serial bonds have to do with the retirement of corporate or municipal debt. All bond structures are governed by their individual bond indentures, which are the contracts that govern the structures of the bonds in terms of maturity date or serial maturities, coupon rate, use of funds, sinking fund, call date and so on. Sinking fund and serial provisions are particularly popular during periods of high interest rates.
Sinking Fund Bonds
Sinking funds are separate accounts, generally held by a trustee, into which the bond issuer regularly deposits principal payments. The fund is created so the issuer can accumulate enough money, plus interest earned on that money in this separate account, to pay the principal in full at maturity. This provision for setting aside money to pay the principal lessens risk, so it is often used by a low credit rating issuer, such as a junk bond issuer, to improve the credit rating to investment grade on its issue. Improved credit makes more institutional buyers able to buy the bond and lowers the interest rate the issuer must pay.
Serial bonds also lessen the risk of default and tend to improve the credit rating on the issue, resulting in a lower cost of interest. Serial bonds are made up of a series of successive maturities that retire portions of the bond over the term of the bond. In a period of falling interest rates, it allows the issuer to replace portions of the original debt by borrowing smaller amounts of money at lower interest rates.
Both corporate and municipal bond issuers depend on debt retirement provisions in their bond structures to increase their credit ratings and lower the cost of borrowing because both sinking funds and serial bonds lessen the risk associated with interest rate fluctuations and potential default by the issuer. During high interest rate periods, the interest earned by the principal deposits in the trust account can greatly lessen the cost of the borrowing. During low interest rate periods, serial bonds tend to be more economical.
Institutional investors, who seek the highest yields possible on the best credit-rated bonds, generally find sinking fund and serial bonds attractive. Sinking fund retirements often start prior to the maturity date of the bond, and the prices paid by the bond issuer to buy bonds for the sinking fund tend to be slightly higher than market prices because there are few bonds available to buy. An institutional portfolio manager may attempt to corner the sinking fund by accumulating a large holding of the sinking fund bonds and refusing to sell until the bonds he holds are among the last remaining outstanding of the issue. This forces the issuing company to pay up for the bonds in order to retire the issue prior to maturity.