Question

Which of the following statements about sinking fund is true? (why is C correct?)

a) A company would prefer to use sinking fund to call bond if bond sells at a discount price.

b)Sinking funds are designed to protect bondholders, so it never hurts the bondholders in any situations.

c)A company would use sinking fund for open market purchase of bond if the interest rate is much higher than its coupon rate.

d) A company would prefer to use sinking fund to call bond if bond sells at a discount price.

Answer 1

C -  A company would use sinking fund for open market purchase of bond if the interest rate is much higher than its coupon rate.

If market rate of interest increases, the bond prices will decreases as the bond prices are negatively correlated with market rate of interest. Let us say market rate of interest = 10% and coupon rate = 10%. So buying a bond with fv = $ 1000, at invetment of $1000 we are getting $100 as interest (10% coupon rate). Now if market rate of interest increases to 20%, it means by investing $500 in market we are getting $100 as interest(20%). Since the bond interest amount will remain fixed(coupon rate and FV didnt Changed), the investor would be ready to give maximum $500 for the bond. Thus value of bodn decreases, and company would use sinking fund for open market purchase of bond if the interest rate is much higher than its coupon rate.