A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in theopen market. The sinking fund provision is really just a pool of money set aside by a corporation to help repayprevious issues and keep it more financially stable as it sells bonds to investors.
Key Takeaways
- A sinking fund is maintained by companies for bond issues, and is money set aside or saved to pay off a debt or bond.
- Bonds issued with sinking funds are lower risk since they are backed by the collateral in the fund, and therefore carry lower yields.
- Paying debt off early through a sinking fund saves a company interest expense and puts the company on firmer financial footing.
- Sinking funds can also be used to finance the redemption of callable bonds.
How Bond Repayment Works
Typically, corporate bond agreements (also called indentures) require a company to make periodic interest payments to bondholders throughout the life of the bond, and then repay the principal amount of the bond at the end of the bond's lifespan.
For example, let's say Cory's Tequila Company (CTC) sells a bond issue with a $1,000 face value and a 10-year life span. The bonds would likely pay interest payments (called coupon payments) to their owners each year. In the bond issue's final year, CTC would need to pay the final round of coupon payments and also repay the entire $1,000 principal amount of each bond outstanding.
This could pose a problem because while it may be very easy for CTC to afford relatively small $50 coupon payments each year, repaying the $1,000 might cause some cash flow problems, especially if CTC is in poor financial condition when the bonds come due. After all, the company may be in good shape today, but it is difficult to predict how much spare cash a company will have in 10years' time.
WhyCreatea Sinking Fund?
To lessen its risk of being short on cash 10 years from now, the company may create a sinking fund, which is a pool of money set aside for repurchasing a portion of the existing bonds every year. By paying off a portion of its debt each year with the sinking fund, the company will face a much smaller final bill at the end of the 10-year period.
As an investor, you need to understand the implications a sinking fund can have on your bond returns. Sinking fund provisions usually allow the company to repurchase its bonds periodically and at a specified sinking fund price (usually the bonds' par value) or the prevailing current market price. Because of this, companies generally spend the dollars in their sinking funds to repurchase bonds when interest rates have fallen (which means the market prices of their existing bonds have risen), as they can repurchase the bonds at the specified sinking fund price, which is lower than the market price.
Callable Bonds vs. Sinking Funds
This mechanism may sound very similar to a callable bond, but there are a few important differences investors should be aware of. First, there is a limit to how much of the bond issue the company may repurchase at the sinking fund price (whereas call provisions generally allow the company to repurchase the entire issue at its discretion).
However, sinking fund prices established in bond indentures are usually lower than call prices, so even though an investor's bond may be less likely to be repurchased through a sinking fund provision than a call provision, the holder of the bond with the sinking fund stands to lose more money should the sinking fund repurchase actually occur.
Where Does a Sinking Fund Arrangement Show Up on a Company's Balance Sheet?
If a company utilizes a sinking fund in relation to a bond issue, the sinking fund is listed as a long-term (noncurrent) asset on the balance sheet. Since the money in the sinking fund is reserved strictly for the repayment of bonds, it cannot be used to pay for short-term liabilities.
When Did Sinking Funds Originate?
Sinking funds have appeared throughout history, mainly as ways for sovereign governments to help repay war bonds and reduce national debts. Some of the earliest mentions date back to middle-ages Italian city-states, but the sinking fund concept is often attributed to efforts by the English crown during the 17th and 18th centuries.
What Is a Sinking Fund for Personal Budgeting?
Similar in concept to a sinking fund for a corporation that issues and repays bonds, a sinking fund for household finances involves setting aside a certain amount of money each month to help pay off debts or to finance large purchases in the future. The idea is that by consistently saving relatively small amounts of money, there will eventually be enough stored up to spend toward something more significant.
The Bottom Line
A sinking fund provision makes a bond issue simultaneously more attractive to an investor (through the decreased risk of default at maturity) and less attractive (through the repurchase risk associated with the sinking fund price). Investors should review the details of a sinking fund provision in a bond's indenture and determine their own preferences before investing their money into any corporate bond.
FAQs
A sinking fund adds an element of safety to a corporate bond issue for investors. Since there will be funds set aside to pay off the bonds at maturity, there's less likelihood of default on the money owed at maturity. In other words, the amount owed at maturity is substantially less if a sinking fund is established.
What is a sinking fund explain your answer in detail? ›
A sinking fund is a type of fund that is created and set up purposely for repaying debt. The owner of the account sets aside a certain amount of money regularly and uses it only for a specific purpose.
What is a sinking fund Quizlet? ›
sinking fund. provision that requires the corporation to retire a portion of the bond issue each year. The purpose of the sinking fund is to provide for the orderly retirement of the issue. A sinking fund typically requires no call premium.
Are sinking funds good or bad? ›
They allow you to save for infrequent expenses and plan for large expenses over time. Having sinking funds can help prevent you from withdrawing money from your emergency fund or going into debt to pay for things. You can use a budgeting app, like You Need a Budget (YNAB) or PocketGuard, to monitor your sinking funds.
How does having a sinking fund help you avoid debt? ›
Saving for large purchases over time. A sinking fund lets you spread out a large purchase over time by saving a little at a time. Avoiding using a credit card or taking out a loan. Without a sinking fund, you might need to use a credit card to pay for a large expense, putting you into debt.
What is a sinking bond? ›
What Is a Sinkable Bond? A sinkable bond is a type of debt that is backed by a fund set aside by the issuer. The issuer reduces the cost of borrowing over time by buying and retiring a portion of the bonds periodically on the open market, drawing upon the fund to pay for the transactions.
What is a sinking fund for dummies? ›
Wondering “what are sinking funds in budgeting?” Sinking funds are funds you set aside to save toward a significant, pre-planned goal. You save money over time instead of dipping into your checking account for a considerable chunk of cash to cover a particular purchase or event.
Why is it called a sinking fund? ›
A sinking fund is a savings method that helps fund a specific purchase or expense by a certain date. The term “sinking fund” was first used in 18th century England to refer to funding public debts,¹ but the meaning has changed over the years.
What comes out of the sinking fund? ›
A sinking fund is a reserve account that's set up to protect the value of a property. It is often used as an investment vehicle by investors who want to make sure their money will not be lost or devalued over time. Sinking funds can be used for various purposes, including: covering the costs of repairs and maintenance.
What is another word for sinking fund? ›
What is another word for sinking fund?
| nest egg | fund |
|---|
| rainy day fund | money put by for a rainy day |
| mad money | life savings |
| emergency funds | reserve fund |
| savings account | unexpended balance |
49 more rowsA sinking fund is for those expenses you know are coming and can plan ahead for—like your kid's soccer season or the bridesmaid dress you need for your friend's wedding. An emergency fund, on the other hand, is for unexpected expenses.
Is a bond sinking fund a current asset? ›
The bond sinking fund is a noncurrent (or long-term) asset even if the fund contains only cash.
What are the disadvantages of sinking fund? ›
Sinking funds, however, also have certain drawbacks, such as the following: Slow development – saving for a significant cost might take a while, and if it takes a while to accomplish your savings target, you can become disheartened.
What is the 50 30 20 rule? ›
The 50-30-20 rule recommends putting 50% of your money toward needs, 30% toward wants, and 20% toward savings. The savings category also includes money you will need to realize your future goals.
What is the sinking fund provision of a bond? ›
Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. A sinking fund reduces credit risk but presents reinvestment risk to bondholders.
Is a bond sinking fund a cash equivalent? ›
The company would classify the bond sinking fund as a non-current asset on its balance sheet. Basically, its just cash set aside by the company to cover any bond payments it would need to make to holders of the bonds.
What is the sinking fund formula? ›
The sinking fund formula is typically calculated as S= (P * i) / (1 - (1 + i)^-n). This formula helps businesses determine the amount of money they need to set aside periodically to cover the total amount due at the maturity of their debt.
What does a sinking fund investment account always show? ›
Sinking fund investment account sometimes shows a debit balance and sometimes it shows a credit balance.
How much is a sinking fund? ›
Usually, these funds are charged as a percentage of the overall service charges you pay. As a rule of thumb, sinking fund fees are usually set at 10% of the total cost of the service fees. That means if you live in an expensive complex with high maintenance fees, your sinking fund will be higher as a result.
