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What Is a Purchase Fund?
A purchase fund is a feature of some bond indentures and preferred stock that requires the issuer to make an effort to purchase a specified amount of securities if they fall below a stipulated price (usually par value).
Par value is a term that often describes a bond, but can also apply to a stock. Par value is the face value of a bond. It is the principal amount that the lender, or investor, is lending to the borrower, or issuer.
A purchase fund is similar to a sinking fund provision. A sinking fund is formed by periodically putting money aside to eventually pay back a debt or replace an asset that has depreciated.
The purchase fund can be an advantage to investors if the fund is trading below par value because the company must pay par to repurchase the bonds.
Key Takeaways
- A purchase fund is used to buy securities when their value has fallen below the original dollar amount assigned by the issuer.
- The fund is similar to a sinking fund provision, in which money is periodically set aside to pay back a debt or replace a failing asset.
- A purchase fund can benefit an investor in that if the fund falls below par value, the company has to pay par value to repurchase the bonds from the investor.
Purchase Fund Explained
A purchase fund is a fund that is only used by the issuers to buy stocks or bonds when those securities have fallen below the original dollar amount assigned by the issuer. This type of fund can be beneficial to an investor in that if the fund is trading below par value, the company has to pay par value to repurchase the bonds from the investors. If the prices fall, the fund allows the company to redeem its securities at a discount. This redemption fund cuts the risk that the company will be unable to redeem its bonds at maturity.
A purchase fund is similar to a sinking fund provision, with a few key differences. A sinking fund is a means of repaying funds borrowed through a bond issue. The funds are repaid through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. Rather than the issuer repaying the entire principal of a bond issue on the maturity date, another company buys back a portion of the issue annually and usually at fixed par value or at the current market value of the bonds, whichever is less. A sinking fund adds safety to a corporate bond issue. They can be found in preferred stocks, cash or other bonds.
What Is Par Value?
Par value is the face value of a security. The par value of bonds is typically higher than that of stocks and can vary based on whether it is a corporate bond, municipal bond, or a federal bond. Typically a corporate bond has a $1,000 face value, while a municipal bond typically has a $5,000 face value and a federal bond has a $10,000 face value.
A company might issue $1,000,000 bonds by issuing 1,000 bonds at $1,000. When the bond matures, the borrower will pay back the face value, in this case, $1,000, to the lender.
The par value of stocks is typically small and fairly arbitrary, such as one cent per share. The preferred stock will sometimes have a higher par value because it is used to calculate dividends.
Real World Example
Let's say the trucking company Rev decides to issue $20 million of bonds that are due to mature in 10 years. If Rev has a purchase fund, they might be required to retire a certain amount in bonds each year for 10 years, perhaps $2 million per year. To retire those bonds, Rev must deposit $2 million a year into a purchase fund. That purchase fund has to be separate from Rev's operating funds and used exclusively to retire debt. By using this strategy, Rev can guarantee it will pay off the $20 million in 10 years.