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FRM Part I · FRM Exam Part I · Corporate Bonds

A corporate bond indenture includes a sinking fund provision requiring the issuer to retire a portion of the issue each year. From the perspective of a bondholder, which statement about this feature is most accurate?

A sinking fund lowers credit risk because the issuer retires debt gradually before maturity, but bondholders face the chance that their bonds are called early at par, creating reinvestment risk, particularly when the bonds trade above par.

  1. AIt reduces credit risk but exposes the holder to the possibility of early redemption at parCorrect
  2. BIt increases credit risk because the issuer must divert cash from operations
  3. CIt gives the holder the right to convert the bonds into equity at a set ratio
  4. DIt allows the issuer to skip coupon payments in years when a redemption is made

Explanation

A sinking fund forces the issuer to retire debt gradually, usually at par, which lowers default risk at maturity. However, a holder whose bond is selected for retirement loses a bond that may be trading above par, so there is reinvestment risk. The other options describe unrelated features or misstate the effect.

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