Information Asymmetry and the Sinking Fund Provision

Publication Type

Journal Article

Publication Date

1993

Abstract

A large proportion of corporate bonds contain a sinking fund provision. The wide use of sinking funds has prompted both theoretical and empirical investigations. However, none has provided a satisfactory explanation for the existence of a sinking fund provision. The signalling implications of sinking funds is examined, and it is shown that, under information asymmetry, the sinking fund amortization rate provides a credible signal for the quality of the firm. In a separating equilibrium, better quality firms choose higher sinking fund amortization rates in their bond issues. A latent index model is proposed for testing the hypothesis of sinking fund signalling. The empirical evidence indicates that the sinking fund amortization rate signals the credit quality of the firm.

Discipline

Business

Research Areas

Quantitative Finance

Publication

Journal of Financial and Quantitative Analysis

Volume

28

Issue

3

First Page

399

ISSN

0022-1090

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