Chapter 2 Practice Question Answers
- 1. Answer: B. A sinking fund is an escrow account used specifically for the purpose of paying the principal on a bond. An issuer makes periodic payments into the fund to assure payment when the principal comes due or to buy back or “call” the bond at some point in the future prior to maturity. A sinking fund does not collateralize the asset but is a depository for some of the collateralized assets.
- 2. Answer: C. A bond refunding is the replacement of existing bonds with new “refunding” bonds. The issuer of refunding bonds often seeks to lower its interest payments by paying off its previously issued (refunded) bonds with newly issued bonds that pay interest at a lower rate. Another reason to refund existing bonds may be to release the issuer from legal covenants or restrictions in the original indenture.
- 3. Answer: B. A bond refunding is the replacement of existing bonds with new “refunding” bonds. The issuer of refunding bonds seeks to lower its interest payments by paying off its previously issued (refunded) bonds with newly issued bonds that pay a lower interest rate. An issuer typically uses advance refunding when interest rates have dropped significantly, but the next call date is not in the near future. Advance refunding bonds may also be issued to terminate restrictive bond covenants in the refunded bond.
- 4. Answer: A. A make whole call is a call provision that pays the bondholder, if exercised, the net present value of all payments the investor would have been due had the bond been held to maturity. The investor is always assured of being fully compensated, or “made whole,” when the call occurs. An issuer includes this type of call provision in the bond indenture when it does not expect to use the call but wants to