A company issues a bond with a sinking fund provision. How does this affect investors?

Question

BlackTom AI · Accepted Answer

Exploring how a sinking fund provision affects a bond tells us what the mechanism does for investors.
Option 1 proposes that default risk increases and bond price falls. In reality, a sinking fund requires the issuer to retire a portion of the issue periodically, which generally lowers credit risk because there are scheduled repayments, not increased risk. So this option misstates the effect on risk and price.
Option 2 states that default risk is reduced, and the bond price rises. This aligns with the logic that a sinking fund provides a structured amortization of debt, reducing the likelihood of default and giving investors greater protection, which tends to push the price higher and the yield lower.
Option 3 claims that reinvestment risk increases and price falls. While sinking funds alter cash flow patterns, the primary impact is on credit risk and protection; reinvestment risk is a more nuanced concern tied to the predictability and timing of cash flows, but the standard effect is not that it increases reinvestment risk in a way that lowers price. This makes the statement misleading.
Option 4 asserts there is no impact on bond price. Given the enhanced protection and the amortization schedule, markets typically price in the lower risk, meaning some price appreciation or yield adjustment occurs, so this option is incorrect.
In summary, the core idea is that a sinking fund reduces default risk for investors by ensuring periodic principal repayment, which generally supports a higher price relative to a non-sinking fund bond with similar features, and this is most accurately captured by Option 2.

Business Finance Exam 2 Practice

A company issues a bond with a sinking fund provision. How does this affect investors?

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