Bond terms and conditions explained

Sinking-Fund Provisions
A sinking fund is money taken from a corporation’s earnings that is used to redeem bonds periodically, before maturity, as specified in the indenture. If a bond issue has a sinking-fund provision, a certain portion of the issue must be retired each year. The bonds retired are usually selected by lottery.

One investor benefit of a sinking fund is that it lowers the risk of default by reducing the amount of the corporation’s outstanding debt over time. Another is that the fund provides price support to the issue, particularly in a period of rising interest rates.

However, the disadvantage – which usually weighs more heavily on investors’ minds, especially in a falling-rate environment – is that bondholders may receive a sinking-fund call at a price (often par) that may be lower than the current market price of the bond.

Other Types of Redemptions
Bond investors should be aware of the possibility of certain other kinds of calls. Some bonds, especially utility securities, may be called under what are known as Maintenance and Replacement fund provisions (which relate to upgrading plant and equipment). Others may be called under Release and Substitution clauses (which are designed to maintain the integrity of assets pledged as collateral for some bonds) and Eminent Domain clauses (which have to do with paying off bonds when a governmental body confiscates or otherwise takes assets of the issuer).

Ask about these and any other special redemption provisions that may apply to bonds you are considering. You can avoid the complications and uncertainties of calls altogether by buying only noncallable bonds without sinking-fund provisions.

If you do buy a callable bond and it is called, be aware that its actual yield will be different than the yield to maturity you were quoted. So ask an investment professional to tell you what the yield to call is as well.

Puts
Just as some issuers have the right to call your bond prior to maturity, there is a type of bond – known as a put bond – that is redeemable at your option prior to maturity. At specified intervals, you may “put” the bond back to the issuer for full face value plus accrued interest.

In exchange for this privilege, you will have to accept a somewhat lower yield than a comparable bond without a put feature would pay.

Understanding Collateralization
In the event a corporation goes out of business or defaults on its debt, bondholders, as creditors, have priority over stockholders in bankruptcy court. However, the order of priority among all the vying groups of creditors depends on the specific terms of each bond, among other factors.

One of the most important factors is whether the bond is secured or unsecured. If a bond is secured, the issuer has pledged specific assets (known as collateral) that can be sold, if necessary, to pay the bondholders.

If you buy a secured bond, you will “pay” for the extra safety by receiving a lower interest rate than you would have got on a comparable unsecured bond.