Safety in a Sinking Fund
Bonds are considered one of the greatest investment options on the market. You are basically giving a loan to a company, or municipality, and earning a yield along the way. Corporate bond yields will be a taxable event, at long-term rates. Municipal bond yields come in the coveted tax-free form, but the yields are normally quite a bit lower than corporate bonds. As adjusted for taxes, however, either way you normally end up in the same range relative to realized gain. There are a number of different bonds, and each there are certain features an investor should know more about before making this long-term purchase. There are also terms every investor should be familiar with when looking to invest in the bond market.
What Does Fidelity Mean?
We often hear words that we just don’t understand. In the investment world, fidelity means strict observance of promises and duties. The word itself is widely used in an industry where some of the goings on are the antithesis of such. That being said, as this industry evolved, fidelity bonds were created. Investment firms are required to have fidelity bonds, also known as honesty bonds. These bonds are an insurance policy. This policy serves to protect employers against losses, be those losses monetary or physical, caused by actions of its employees. Firms have to carry bonds that reflect the net capital of the firm. Theft, forgery and fraudulent trading are a few examples of what these bonds cover.
The reason firms are able to have insurance protecting them is because brokers, traders, investment bankers and even some sales assistants are required to have a Series 7 license to act in the capacity of a broker, trader, banker and in other capacities where even the discussion of investments is part of their employment responsibilities. This license squarely makes the broker responsible for their actions in a definitive way. Add to this most every brokerage firm has arbitration agreements with clients, which mean any claims against brokers will be conducted in arbitration and not in a traditional courtroom setting. There is generally a panel of three, and one being a judge, who decide these matters. The definitive issue regarding arbitration is once a decision has been reached, all parties forfeit rights to appeal the decision. Most firms, so as to further insulate the firm’s assets, are limited liability corporations. That being said, the fidelity bond comes into play as the license brokers have require they exercise particular jurisprudence. Failure to do so will land them in arbitration to answer for their actions, and this bond ensures that firms enjoy some protection from this process.
Why Buy Bonds?
Congruent with this discussion on safety, protection, insurance sprinkled with a touch of malfeasance, a discussion of a bond sinking fund is a natural progression! The reasons bonds are such a good investment is because in the event of corporate dissolution, at any time along the normally lengthy trajectory from purchase to maturity, the holders of these bonds are assured they will get their money back as assets of the company are liquidated to satisfy debts. This is the way it should work anyway. There are also various bonds with different features. One of these features that investors looking for, and that which provides an added layer of protection, are those issues that have a sinking fund provision.
What is a Sinking Fund?
In an attempt to make bonds particularly attractive to investors, Corporations set aside a pool of money to satisfy the bond issue, should the need arise. A sinking fund definition is therefore just putting funds in a separate account. The fund provides an added layer of protection for investors. These funds cannot be counted as funds a company can use to satisfy current obligations. They are held outside the working capital section of the company’s balance sheet and can only be used to retire the bond in question. Ostensibly this would seem like more protection for investors, but this is not always the case.
There is a distinct benefit to companies that issue bonds with a sinking fund provision. There is a provision in sinking funds that allow the issuer to repurchase at a specified price, or at the prevailing market price. This provision may sound familiar as it can be likened to the call feature of bonds. In any case, interest rates will undoubtedly fluctuate during the lengthy life of a bond. If a company has the money in a separate account ready to repurchase a bond issue when interest rates are low, and their bond values have therefore risen, they can recognize a gain and retire that issue. There is not a company on the planet that will not do this! This move is even more attractive to a company as it moves all that segregated capital back into the working capital pool of funds. It just makes sense to repurchase when the time is right.
Why Buy a Bond with a Sinking Fund?
Sinking funds are a great way for investors to buy bonds, as they are assured to get their money back immediately should a company fail during the life of the bond. A company may want to quickly raise money, and sinking fund bonds are always more attractive to buyers, which means they will be purchased quickly. The time when this sort of purchase comes with an added caveat is when interest rates are suspected to go lower than they currently are. Companies are in business for one reason: to make money. More to this point, they are going to be as advantageous as possible when opportunity presents itself.
Interest rates are going to fluctuate during the life of a bond. If a bond buyer wants added protection that comes in the form of a sinking fund, they must also realize every sinking fund has the repurchase provision, and that this will likely happen if the opportunity arises. Most investors who look for these bonds prefer the added insurance benefit of the sinking fund feature, and will forgo concerns about a future repurchase so as to err on the side of safety. That being said, bonds, even those without sinking funds, are a fairly safe investment.
If an investor is working with a bond broker, they will be able to help investors move the funds from a called, or repurchased, bond into another investment. The bond world is filled with daily issues of new opportunities, so if you are an investor looking for the safest way to proceed, buy the sinking fund bond. There will be another equally attractive vehicle to invest in when a repurchase occurs. Bond investors buy bonds for the yield, and as long as those payments are realized, this is all that matters. Safely invest in bonds with a sinking fund, and then deal with the liquid results of repurchase when the time comes.