Information Asymmetry and the Sinking Fund Provision

Abstract

This paper examines the signalling implications of sinking funds and shows 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. Empirical evidence indicates that the sinking fund amortization rate signals the credit quality of the firm.