Information Asymmetry and the Sinking Fund Provision

• Main Author: WU, Chunchi
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 1993
• Subjects: Business
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/808
• Institution: Singapore Management University

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.