Contemporary techniques for valuing a single interest-rate-sensitive option can be extended to the valuation of a package of interrelated embedded options, such as those contained in sinking fund issues. A typical public sinking fund issue may contain several options a conventional call provision, a sinking fund acceleration feature, and a delivery option that allows the issuer to satisfy its sinking fund requirements through market purchases.
Analysis reveals that delivery and call options are nearly additive. That is, the coupon premium on a callable sinking fund bond (relative to the coupon on a comparable optionless bond) plus the coupon premium on a deliverable sinking fund bond will approximate the premium for a sinking fund bond with both call and delivery options. This is because the two options are exercised in opposite interest rate environments. Call and acceleration options, however, are largely redundant, because, in the presence of a call option, the acceleration provision is valuable only within a very narrow range of interest rate movements.
Distribution also affects the value of sinking fund bonds. Opportunistic investors can increase the value of an outstanding sinking fund issue by several points by accumulating a significant portion of the issue. At the same time, by making advance market purchases of sinking fund payments, the issuer can take defensive action against accumulators. These purchases reduce the issue's theoretical value by a quantifiable amount.
These findings have implications for the optimal management of sinking fund bonds by both investors and issuers.