Smart Bond Investing—Understanding Risk
Refunding Risk and Sinking Funds Provisions
A sinking fund provision, which often is a feature included in bonds issued by industrial and utility companies, requires a bond issuer to retire a certain number of bonds periodically. This can be accomplished in a variety of ways, including through purchases in the secondary market or forced purchases directly from bondholders at a predetermined price, referred to as refunding risk.
Holders of bonds subject to sinking funds should understand that they risk having their bonds retired prior to maturity, which raises reinvestment risk. Unlike other bonds subject to call provisions, depending upon the sinking fund provision, there may be a relatively high likelihood that the bondholders will be forced to redeem their bonds prior to maturity, even if market-wide interest rates remain unchanged.
It is important to understand that there is no guarantee that an issuer of these bonds will be able to comply strictly with any redemption requirements. In certain cases, an issuer may need to borrow funds or issue additional debt to refinance an outstanding bond issue subject to a sinking fund provision when it matures.