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 the open market. This provision is really just a pool of money set aside by a corporation to help repay previous issues.
How Bond Repayment Works
Typically, bond agreements (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 ten 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 ten years' time.
What Are the Reasons for Creating a Sinking Fund?
To lessen its risk of being short on cash ten 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 price 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.
This 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.
The Bottom Line
As you can see, 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.
(For further reading, see Corporate Bonds: An Introduction to Credit Risk.)