What it means
Bonds are loans, and the issuer must repay them at maturity. A purchase fund is one way of reducing the amount outstanding before then, by making the issuer set aside cash each year and use it to buy the bonds back from investors.
The key feature is the price condition. If the bonds are trading below par, the issuer must use the money to buy them, and if the market price is above the stated level, the issuer is not obliged to buy and can hold the cash for later.
This differs from a sinking fund. A sinking fund normally requires the issuer to redeem a set amount of bonds at a fixed price whatever the market is doing, whereas a purchase fund only operates when buying in the market is attractive to the issuer.
For investors, the provision offers some support. Regular buying by the issuer creates demand for the bonds when their price is weak, and the reduced debt balance lowers the risk of the final repayment.
For the issuer, the benefit is that repurchasing at a discount saves money. If it buys a bond below face value and then cancels it, the debt is reduced by the full face value even though less cash was spent.
The nuance is that the fund provides no guarantee. If the price stays above the stated limit, no bonds are bought, and the investor receives no extra protection other than what the bond terms provide.
A careful investor therefore reads the exact wording of the provision before relying on it.
In practice
Real-world examples.
Example
A utility company issued 20-year bonds that carry a purchase fund provision. When market interest rates rise and the bonds fall to 94% of face value, the treasury buys back $3,000,000 of the debt using the fund. This reduces both the principal owed and future interest payments.
Example
A property company's bonds trade at 102% of face value because investors like the yield. The trustee reports that the purchase fund conditions are not met, so the annual deposit stays in cash and the treasury invests it in short-term deposits. The cash earns a small return while it waits for a buying opportunity.
Example
A bond investor reading the terms of a new issue notices a purchase fund clause. She values it as a modest source of price support, though she does not rely on it because buying is only required below a stated price. Her analysis focuses on the issuer's cash flow and credit quality instead.
Formula
Calculation
Bonds repurchased = cash available / purchase price per bond
Saving against face value = face value retired - cash spent
Suppose an issuer must put $1,000,000 into its purchase fund and the bonds, with a $1,000 face value, trade at 96% of face value, which is $960 each. Bonds that can be bought = 1,000,000 / 960 = 1,041.67, so 1,041 whole bonds. Cash spent = 1,041 x 960 = $999,360. Face value retired = 1,041 x 1,000 = $1,041,000. Saving against face value = 1,041,000 - 999,360 = $41,640.Case study
Seen in the real world.
Lakeland Energy Partners is an illustrative, fictional company that sold $150,000,000 of ten-year bonds with a purchase fund. Each year it had to put $5,000,000 into the fund and buy bonds if they traded below 98% of face value.
In year three, interest rates rose and the bonds fell to 93%. The treasurer used the full $5,000,000 to buy bonds with a face value of about $5,376,000, a saving of roughly $376,000 against par.
She reported the purchase to the trustee, cancelled the bonds and updated the debt schedule, which also reduced future interest payments. The illustrative lesson is that a purchase fund turns a fall in the company's own bond price into an opportunity to cut debt cheaply. The board noted that the repurchase worked in the company's favour only because rates had risen, not because of any change in its performance.
Watch out
Common mistakes.
- Confusing a purchase fund with a sinking fund, when a sinking fund requires redemption at a set price and a purchase fund only buys at market prices below a stated level.
- Assuming the fund guarantees repayment, when it only reduces the debt if bonds are available at the required price.
- Forgetting to cancel the repurchased bonds and update the debt records, which leaves the accounts showing a liability that no longer exists.
Questions
People also ask.
Who benefits from a purchase fund?
Both sides benefit, because investors get some price support and the issuer can retire debt below face value.
Does the issuer have to buy bonds every year?
Only if they can be bought at or below the stated price, otherwise it can keep the money until the conditions are met. Interest earned on the idle cash belongs to the issuer unless the agreement says otherwise.
How is a purchase fund accounted for?
The money set aside is shown as cash or restricted funds, and bought-back bonds are removed from debt, with any difference between the price paid and the carrying value recorded as a gain. Auditors will usually ask to see the trustee's confirmation of the cancelled bonds.
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