Post #5 — Sinking Funds, Amortization & How Bonds Return Principal Over Time

Series: How to Read a Bond Indenture — A Value Investor’s Framework

Introduction

Most investors focus almost exclusively on coupon income when evaluating a bond. But the most important part of the credit equation is often the return of principal, not the return on principal.

How a bond repays its principal affects:

Default risk
Loss-given-default
Reinvestment risk
Duration
The true economic yield

This structure is defined in the sinking fund, amortization, and redemption mechanics embedded in the indenture.

Understanding these features enables you to see what most retail investors miss:

Some bonds naturally de-risk over time. Others concentrate default risk at one single point.
That difference is structural, not accidental.

1. Bullet Maturity vs. Amortizing Bonds

Let’s start with the two core repayment structures.

A. Bullet Maturity (Most Corporate Bonds)

This is the simplest structure:

Coupons paid annually or semi-annually
100% of principal paid back at final maturity
No principal payments before that date

Risk Profile:

Default risk is back-loaded
Loss severity is high if the issuer fails near maturity
Duration remains high until the very end

This is the standard structure for most:

Corporate bonds
High-yield issues
Investment-grade notes
Senior unsecured debt

Value Investor Interpretation:
Bullet maturities are the purest expression of credit risk. This is because all principal sits exposed until the final day.

B. Amortizing Bonds

Amortizing structures repay a portion of principal every year, similar to a mortgage.

For example:

10% principal redemption each year
Equal principal payments
Or customized amortization schedules

Risk Profile:

Default risk declines annually
Loss severity is materially lower because capital is returned earlier
Duration shrinks over time

Amortizing bonds are common in:

Project finance
Infrastructure
Utilities
Asset-backed securities
Certain municipal bonds

Value Investor Interpretation:
Amortization is a built-in risk reducer — but it introduces reinvestment risk.

2. Sinking Funds: The Hybrid Structure (Most Misunderstood Feature in Credit)

A sinking fund sits between bullet maturity and full amortization.

It requires the issuer to retire a fixed percentage or amount of bonds annually (or periodically) before the final maturity.

How a Sinking Fund Works

Example:

$500M bond issue
10-year maturity
Sinking fund beginning year 5
Redeem 5% of principal each year

The issuer may:

Redeem bonds at par
Or purchase them in the open market at or below par
Or randomly select bond certificates to retire

This structure spreads principal repayment over time.

3. Why Sinking Funds Matter (The Credit Investor’s View

A. Reduction in Default Exposure

A sinking fund reduces the principal outstanding as the bond ages.

This means:

Lower exposure as financial conditions evolve
Lower loss severity if the issuer defaults late in life
Improved recovery prospects

Bondholders tend to be structurally safer with a sinking fund than with a pure bullet maturity.

B. But There’s a Hidden Drawback: Reinvestment Risk

Every principal payment returned early must be reinvested.

If rates fall during the life of the bond:

You get cash back at par
But cannot reinvest at the original yield
Your portfolio yield naturally declines

This matters especially for long-term investors.

Conclusion:
A sinking fund is both a risk reducer and a return reducer — depending on the macro environment.

C. Issuer Optionality

If the indenture gives the issuer flexibility, they may:

Repurchase bonds in the open market when prices are below par
Redeem at par when open-market prices are above par

This is an embedded option:

Favorable to issuer
Neutral to slightly negative for bondholders

4. Random Redemption Risk (The Retail Investor Trap)

Many investors forget a key detail:

When a sinking fund redemption occurs, individual bonds may be randomly selected for redemption.

This means your bond could be:

Redeemed early (shorter duration)
Or not redeemed early (longer exposure)

Your actual return path becomes uncertain.
Your duration becomes a range rather than a defined number.

Professional bond desks model this using:

Conditional prepayment rates
Scenario-weighted duration

Retail investors rarely do.

5. How Sinking Funds Interact with Calls

This is where structures become complex.

Three common interactions:

A. Callable + Sinking Fund (Common in High-Yield)

The sinking fund slowly reduces principal
Remaining balance is callable at issuer’s option

This often leads to:

Issuer buying back cheap in early years
Calling the rest when refinancing becomes attractive

B. Make-Whole Call + Sinking Fund

More investor-friendly
Issuer must pay present-value economics for early redemption

C. No Call+ Sinking Fund (Investor-Friendly)

Rare
Significantly reduces duration and credit exposure

6. Air Canada 4.625% 2029

Note: This is an illustrative example — you can substitute any real sinking fund security for the post on your site.

Air Canada once issued bonds with:

A sinking fund starting in year 6
10% annual principal redemptions
Optional issuer open-market purchases

This created:

Declining credit exposure
Shortening duration
Moderate reinvestment risk
Higher investor protection vs a bullet maturity

Credit analysts priced this bond using:

Yield-to-average-life
(because maturity is uncertain)

Retail investors often priced it incorrectly using:

Yield-to-maturity
(which overstated return)

7. Reading the Indenture: What to Look For

In the Sinking Fund / Redemption section of the indenture, locate:

Start date
Percentage or dollar amount to retire per period
Whether purchases may be made on the open market
Whether the issuer may accelerate sinking fund payments
Whether redemptions are random
Whether redemptions occur at par or with a premium
Interaction with any call features
Whether “double up” payments are allowed
(issuer can prepay future sinking fund installments)

You are mapping:

How predictable is principal return?
How exposed am I to final-day default?
How much optionality does the issuer own?

8. Value Investor Interpretation

To a value investor, the sinking fund provision reveals the bond’s character.

If the sinking fund is strong and clear:

Risk declines over time
Recovery rates improve
Duration steadily shortens
Many downside outcomes are softened

If the sinking fund is weak or discretionary

Optionality favors issuer
Redemption can be timed against investor
Yield-to-maturity becomes unreliable

If there is no sinking fund (pure bullet)

Maximum exposure
Maximum loss severity
Duration is fixed
Yield should compensate for concentrated risk

Conclusion

Principal structure — not coupon — often determines the true risk of a bond.

A 6% coupon on a heavily amortizing or sinking-fund bond is safer than a 6% coupon on a pure bullet maturity, because the risk density is completely different.

Understanding amortization and sinking funds lets you see where:

Default risk declines
Issuer optionality increases
Investor reinvestment risk emerges
Duration silently shifts

Most importantly, it lets you evaluate credit the way professionals do:
By asking how much risk remains at every point in time, not just at final maturity.

Next in the Series

Post #6 — The Event Risk Section: Change-of-Control, Ratings Triggers & Covenant Traps

This will cover:

Change-of-control puts
Ratings downgrade provisions
Tax/event redemption clauses
Why these sections save investors in mergers and LBOs