CFA Practice Question

CFA Practice Question

What is a reason a sinking fund reduces the investor's risk:

I. the issuer must partially retire a bond before maturity causing a reduction in average maturity
II. it requires the issuer to reduce the issue systematically
III. sinking-fund provisions are being met providing price support for the bond
A. I and II.
B. II and III.
C. I, II and III.
Explanation: These are all reasons why a sinking fund reduces risk and causes a lower yield.

User Contributed Comments 9

User Comment
MikeBarlettano it can be argued that sinking fund, why may not increasing yield, could increase risk, since call risk is an associated risk for fixed income investors
dimos Can anybody help me? Sinking fund gives the issuer the RIGHT or the OBLIGATION to retire a part of the bond when certain conditions are met?
Carol1 Right
jckasn Doesnt option I indicate that the entire bond would be retired before maturity? I always thought that the entire issue would be retired in portions, with atleast some portion being retired at maturity.
brown no it does not imply that.
jpducros Carol1 and Dimos. With sinking fund provisions, the issuer is required to retire part of the principal during the life of the bond. Accelerated sinking fund provision allows the issuer to retire more. For example, it may be required to redeem 5 M par value of Bond each year but may choose to retire 10M. Thus it looks like the sinking fund provision is an Obligation while the Accelerated Sinking fund provision is a Option. Someone can confirm ?
bkballa If the issuer must partially retire a bond before maturity doesn't this increase the reinvestment risk for the bondholders?can someone please explain this
soukhov im also confused - i thought early retirement means higher yields and lower prices...
chandsingh Hi jpducros, that's my understanding as well.The sinking fund provisions are obligatory that is why they reduce credit risk. bkballa - The question only talks about one type of risk so although prepayment risk is increased that is not being discussed.
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