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Question:

Consider the following statements:
Statement 1: Sinking fund arrangements are not likely to reduce credit risk.
Statement 2: Sinking fund arrangements are not likely to reduce reinvestment risk.
Which of the following is most likely?

A Only Statement 2 is correct.
Explaination

• Sinking fund provisions reduce credit risk, as investors receive interest and principal repayments during the term of the bonds.
• Sinking funds increase reinvestment risk, as interest and principal repayments may have to be reinvested at lower rates if interest rates have fallen since the time of purchase.