What is a Sinking Fund?
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 a fixed par value or at the current market value of the bonds, whichever is less.
Breaking Down Sinking Fund
From the investor's point of view, although a bond poses greater interest rate risk the longer it is held, a sinking fund adds safety to a corporate bond issue. The issuing company is less likely to default on the repayment of the remaining principal upon maturity, since the amount of the final repayment is substantially lower.
Sinking funds may be in preferred stock, cash or other bonds. If the issuer makes cash deposits, the trustee uses the money for calling some of the bonds through drawing random serial numbers. The call price is typically the bond's issue price. The closer bonds are to their maturity dates, the closer the call price is to par value.
In contrast, if the issuer deposited other debt into the custodial account, the issuer buys back the bonds. This often happens when the bonds in the open market are selling below par.
Establishing a Sinking Fund
When creating a sinking fund, the issuer sets up a custodial account and makes systematic payments into it. Payments might not begin until several years have passed. Amounts are typically fixed, although variable amounts may be allowed based on earnings levels or other criteria set by the fund's provisions. Unless preferred stock is used with sinking funds, failure to make scheduled principal and interest payments results in defaulting on the loan.
Advantages and Disadvantages of a Sinking Fund
A sinking fund improves a corporation's creditworthiness, letting the business pay investors a lower interest rate. Because of the interest savings, the corporation has more net income and cash flow for funding operations. Additionally, businesses may deduct interest payments given to lenders from their taxes, helping increase cash flow as well. Corporations may use the savings for covering sinking fund payments or other obligations. In addition, investors appreciate the added protection a sinking fund provides, making investors more likely to lend a company money. A business that is controlling its money is less likely to default on outstanding debt.
However, if interest rates decrease and bond prices increase, bonds may be called and investors may lose some of their interest payments, resulting in less long-term income. Furthermore, investors may have to put their funds elsewhere at a lower interest rate, also missing out on potential long-term income.