Sinking Fund

Adviser Nkechi Balogun compares two new municipal issues from the same state. The Harrowgate Township issue repays a portion of its principal on each of the next twenty years. The Calderwood Authority issue repays no principal until a single date twenty years out, when the entire amount comes due. What is the correct classification, and what practical difference follows?

1. A.Harrowgate is a term issue and Calderwood is a serial issue, since Harrowgate makes payments in each of the twenty years.Incorrect and reversed. Repaying principal in instalments across many dates is the SERIAL structure; a single maturity date is the term structure.
2. B.Harrowgate is a serial issue and Calderwood is a term issue; term issues typically carry a sinking fund and trade as dollar bonds, while serial issues are quoted on a yield basis.Correct. The classification turns on the principal repayment schedule, and the quotation conventions follow from it.
3. C.Harrowgate must be a general obligation bond and Calderwood must be a revenue bond, because maturity structure determines the security pledged.Incorrect. The structures are commonly associated with those security types but do not determine them. Either pledge can use either structure.
4. D.The two are economically identical, since both repay the same principal over the same twenty-year period.Incorrect. Their cash flow timing, duration, reinvestment profile and quotation conventions all differ materially.

Why: The Harrowgate issue has a SERIAL maturity structure: a slice of principal matures each year, so the issue is really a package of bonds with staggered maturities and the issuer debt service stays comparatively level across the life of the issue. General obligation bonds supported by tax revenues are commonly structured this way. The Calderwood issue is a TERM issue: the whole principal falls due on one date, and issuers typically pair a term structure with a sinking fund into which money is deposited periodically so the balloon can actually be met at maturity. Revenue bonds financing a single large facility are frequently term bonds. The market conventions differ accordingly. Serial bonds are normally quoted on a YIELD basis with a separate yield for each maturity, forming a scale, while term bonds trade as dollar bonds quoted at a price.

The Cedar Point Water Authority's revenue bond indenture provides for a SINKING FUND and separately contains a CATASTROPHE CALL provision. What do these two features do?

1. A.Both permit the issuer to redeem bonds at its option whenever interest rates fall enough to make refinancing attractive.Wrong. That describes an optional call. Neither a sinking fund nor a catastrophe call is exercised on the basis of interest rate movements.
2. B.The sinking fund sets money aside on a schedule to retire bonds before maturity, while the catastrophe call mandates redemption of the issue if the financed facility is destroyed and insurance proceeds are received.Correct. One is a scheduled retirement mechanism; the other is a mandatory call triggered by destruction of the facility.
3. C.Both are credit enhancements purchased from a third-party municipal bond insurer.Wrong. Both are provisions of the issuer's own indenture. No third party is involved.
4. D.The sinking fund guarantees interest payments if revenues fall short, while the catastrophe call protects bondholders against default.Wrong. A sinking fund retires principal; it is not a debt service reserve fund. And a catastrophe call is a redemption trigger, not default protection.

Why: They serve different purposes. A sinking fund requires the issuer to set money aside on a schedule and use it to retire bonds before maturity, either by calling them or by buying them in the open market. It reduces the amount outstanding over time and is generally viewed as a credit strength, since the issuer is not left facing the whole principal at once. A catastrophe call - sometimes called a calamity call - is a MANDATORY redemption triggered when the financed facility is destroyed: insurance proceeds arrive, the facility can no longer generate the pledged revenue, and the bonds are called, typically at par.

Brackenhall Chemical's 20-year debentures may be redeemed at any time at the issuer's option at the GREATER of par or the present value of all remaining scheduled interest and principal payments, discounted at the yield of a comparable Treasury issue plus 25 basis points. Portfolio manager Devi Ramakrishnan asks what this provision means for her position. The best answer is:

1. A.It is a sinking fund provision requiring Brackenhall to retire a stated portion of the issue each year.Incorrect. A sinking fund mandates scheduled retirement of a portion of the issue, usually by lot or open market purchase. Nothing here is scheduled or mandatory.
2. B.It is a put provision allowing Devi to sell the bonds back to the issuer at the make-whole price.Incorrect. The option belongs to the ISSUER ("at the issuer's option"). A put would give the holder the right to require redemption.
3. C.It is a make-whole call: because the redemption price rises as yields fall, calling is rarely economic for the issuer, so the bond behaves much more like a noncallable bond than one with a fixed call price.Correct. Discounting remaining cash flows at a Treasury yield plus a narrow spread makes the call price float upward with the bond's value, which removes most of the issuer's incentive to call and preserves the holder's upside.
4. D.It caps her price appreciation at par if rates fall, exactly as a traditional call at 100 would.Incorrect. That is the effect of a FIXED-price call. Under a make-whole formula the call price itself rises when rates fall, so appreciation is not capped at par.

Why: This is a make-whole call provision. Instead of a fixed call price, the redemption price is computed by discounting the bond's remaining cash flows at a narrow spread over Treasuries. When market yields fall, that present value rises, so the price the issuer must pay to call rises right along with the bond's value. The issuer is therefore "making the holder whole" and almost never gains by calling. Practically, the bond trades and behaves much like a noncallable bond: the holder keeps most of the price appreciation when rates decline and does not suffer the negative convexity of a traditional fixed-price call.

The indenture for Wrenbury Foods' new senior UNSECURED notes contains a covenant stating that Wrenbury will not pledge any of its assets as collateral for other borrowings unless the new notes are equally and ratably secured. Analyst Priyanka Sondhi is asked what this covenant accomplishes. It is:

1. A.A closed-end indenture provision prohibiting Wrenbury from issuing any additional debt of any kind.Incorrect. The covenant does not bar new borrowing. It bars pledging assets to other lenders unless the existing notes share equally in that collateral.
2. B.A sinking fund provision requiring orderly retirement of the notes before maturity.Incorrect. A sinking fund obligates the issuer to retire portions of the issue on a schedule. This covenant says nothing about retiring debt.
3. C.A defeasance provision permitting Wrenbury to escrow government securities and be released from the indenture covenants.Incorrect. Defeasance involves depositing securities in escrow sufficient to service the debt. This clause restricts liens; it does not release the issuer from anything.
4. D.A negative pledge clause, which protects the unsecured noteholders from being subordinated by later secured borrowings.Correct. The clause keeps the issuer from granting liens on its assets to new lenders without giving the existing unsecured notes equal and ratable security, preserving their relative claim.

Why: This is a negative pledge clause. Its purpose is to protect unsecured creditors from being pushed down the capital structure after they have already lent. Without it, the issuer could later grant liens on its best assets to new lenders, leaving the existing unsecured holders with a claim only on whatever is left. The clause does not prevent additional borrowing; it conditions SECURED borrowing on sharing the collateral with the existing notes.