Dealing in corporate bonds isn’t always smooth sailing, but corporations have means to provide investors with a life jacket in the form of a sinking fund.
In personal finance, a sinking fund (or a reserved fund) is a budget category set up to fund a planned future purchase. This could be anything from a new drum kit to a trip to Mexico. In corporate finance, companies use sinking funds to pay off bonds.
What is a sinking fund?
A sinking fund is a fund that a company makes periodic payments to in order to pay off debt capital. The fund could be in the form of preferred stock, cash, or other bonds, but the money will always go toward fulfilling the par value of the bond at its maturity date.
Sinking fund definition:
A sinking fund is a sum of money, formed by periodic payments, used for paying back a debt or saving for a future expense.
Key terms to know:
- Sinking fund provision: a clause written into the fine print stating that there will be a sinking fund associated with the bond
- Bond serial number: a unique number used to identify a bond
- Custodial account: an external account, managed by a trustee, in which companies deposit sinking bond funds
- Default risk: the probability that the bond issuer will not be able to pay off their investors
- Par value: the original price of a bond
- Sinking fund call: an opportunity for a company to buy back some of its bonds
How do sinking funds work?
In order to set up a sinking fund, a company must first create a custodial account, managed by a trustee. It will use this account to periodically set money aside toward paying off its debts.
When it comes to bonds, a sinking fund provision will be written into the small print bond itself. Typically, this provision states that the bond issuer promises to pay back a certain amount into the sinking fund annually, and when these payments will begin.
What does a sinking fund do for the company?
Sinking funds put companies at an advantage in that they improve their creditworthiness, allowing them to pay investors at a lower interest rate. A company with bond sinking funds is more appealing to lend money to because there is less default risk, or chance that it will not be able to pay off investors. Sinking funds can make a company more trustworthy and their bonds more secure.
On the flip side, sinking funds may also disadvantage companies that could make better use of that money elsewhere. Putting money into sinking funds means it can’t be used to fund growth, making company stock less appealing to investors.
What does a sinking fund do for the lender?
As was mentioned above, sinking funds lower bonds’ default risk. This is a benefit for lenders–they can be assured that the company is putting money toward paying off their investment. The value of the bond may also go up, giving the lender the option to sell the bond at a price higher than par value, or the original amount they paid.
There is a risk, however, that they may have to sell their bond back to the company before its maturity date, therefore ceasing to gain interest. This comes into play when a call feature is written into the sinking fund provision. The call feature allows the company to buy back a certain amount of the bonds it has issued at random, using a lottery system to choose random bond serial numbers to identify which ones to buy back. Unlucky investors whose bonds are chosen through this system must sell their bonds back to the company at either par value or the current market price, whichever is lower.
Still lost at sea?
Even if your vessel is in ship shape, there’s always a risk of something going amiss. Sinking funds make investing in bonds more of a safe bet, however, much like a ship setting sail, no matter the precautions you’ve taken there’s always a chance of a storm in the skies or a hidden iceberg in the deep. Companies must carefully consider whether to include sinking fund provisions in their bonds, and investors must consider whether bonds with sinking funds are right for them.
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