Loading the player...

What is a 'Sinking Fund'

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. 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. Also, 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. Also, investors may have to put their funds elsewhere at a lower interest rate, also missing out on potential long-term income.

  1. Sinking Fund Call

    A provision allowing a bond issuer the opportunity to buy outstanding ...
  2. Doubling Option

    A sinking fund provision that gives a bond issuer the right to ...
  3. Serial Bond

    A serial bond is a bond issue in which a portion of the outstanding ...
  4. Sinking Fund Method

    A technique for depreciating an asset in bookkeeping records ...
  5. Income Bond

    An income bond is a type of debt security in which only the face ...
  6. Callable Bond

    A callable bond is a bond that can be redeemed by the issuer ...
Related Articles
  1. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Investing

    Six biggest bond risks

    Bonds can be a great tool to generate income, but investors need to be aware of some of the pitfalls and risks of holding corporate and/or government securities.
  3. Investing

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  4. Investing

    Why Companies Issue Bonds

    When companies need to raise money, issuing bonds is one way to do it. A bond functions as a loan between an investor and a corporation.
  5. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  6. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  7. Financial Advisor

    7 Questions to Consider Before Investing in Bonds

    There is a significant number of questions every investor, private or institutional, should consider before investing in bonds.
  8. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  9. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  1. What are the risks of investing in a bond?

    Learn more about bond market investment risk, including interest rate risk, reinvestment risk, call risk, default risk and ... Read Answer >>
Hot Definitions
  1. Liquidity

    Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's ...
  2. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  3. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  4. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  5. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center