Suppose you are considering two bonds that will be issued tomorrow.Both are rated triple B (BBB,the lowest investment-grade rating),both mature in 20 years,both have a 10% coupon,neither can be called except for sinking fund purposes,and both are offered to you at their $1,000 par values.However,Bond SF has a sinking fund while Bond NSF does not.Under the sinking fund,the company must call and pay off 5% of the bonds at par each year.The yield curve at the time is upward sloping.The bond's prices,being equal,are probably not in equilibrium,as Bond SF,which has the sinking fund,would generally be expected to have a higher yield than Bond NSF.

Question

Quizplus · Accepted Answer

The statement in the question that "Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF" is false. The presence of a sinking fund should lower the yield on a bond since it creates a degree of certainty around the bond's repayment, as a portion of the debt will be retired each year. Therefore, Bond SF is likely to have a lower yield than Bond NSF. This means that Bond SF, with the sinking fund, might actually be priced higher than Bond NSF, resulting in both bonds having equal prices.

Suppose You Are Considering Two Bonds That Will Be Issued