Question

With respect to how it reduces perceived default risk, a “serial bond” is most similar to: a. Having a sinking fund provision. b. issuing the bond at par value. c. Making a bond callable. d. Making the bond AAA-rated. d. Making the bond convertible

Answer 1

b. issuing the bond at par value.

A serial bond is a bond issue that is structured so that a portion of the outstanding bonds mature at regular intervals until all of the bonds have matured. Because the bonds mature gradually over a period of years, these bonds are used to finance projects that provide a consistent income stream for bond repayment. The entire bond issue is sold to the public on the same date, and the maturity dates are stated in the offering documents.

If an issuer reduces the dollar amount of bonds outstanding, it reduces the risk that the issuer misses a principal repayment or interest payment and defaults on the bond issue. While a serial bond issue requires the issuer to repay specific bondholders on a stated date, other bond issues are structured with a sinking fund.

A serial bond structure is a common strategy for municipal revenue bonds because these bonds are issued for fee-generating projects built by states and cities. Assume, for example, that a city builds a sports stadium that is funded with parking fees, stadium concession income, and lease income. If the bond issuer believes that the facility can generate income consistently each year, it can structure the bond for serial maturity dates. As the total amount of bonds outstanding decreases, the future risk on the bond issue defaulting also declines.

The Differences Between Sinking Funds and Serial Bond Issues

In a sinking fund, the issuer makes periodic payment to the bond issue's trustee, and the trustee purchases bonds in the open market and retires the bonds. The trustee represents the interests of the bondholders and must use the sinking fund payments to buy bonds and retire them. Instead of retiring bonds according to a specific schedule, the trustee purchases bond from any bondholder who is willing to sell his holdings. Both sinking funds and serial bond issues reduce the total dollar amount of bonds outstanding over time.