Updated July 14, 2023
Introduction of Sinking Fund
A sinking fund is earmarked for a specific purpose, like paying off debts to settle in the future, making investments, acquisitions, etc. A company that has raised money from bonds or any other debt must repay it on the maturity date, and for that purpose, they set aside funds in sinking funds for future repayment. The money set aside regularly in a sinking fund shall use for its specific purpose.
Explanation
The company establishes a fund to repay its debts, finance planned capital expenditures, and address specific long-term financial requirements. When a company raises debt through bonds, debentures, etc., it also knows the repayment and maturity period. Any business finds it difficult to pay off a sizable sum at maturity, so the sinking fund concept uses a sum set aside and built up over time in the fund with an eye toward future repayment.
Bonds can sometimes have a provision that can even be called back before maturity by using sinking funds to avoid future interest payments, as they have sufficient funds to repay the bond’s maturity value. Predominantly sinking funds maintain for repayment of debts, and are sometimes used to buyback (I.e.) repurchase the shares or bonds issued by the company.
Objectives of the Sinking Fund
- It maintains to reduce the risk of funds being short at the time of repayment of debts. And makes repayment more manageable.
- It is a pool of money saved every year that can be used to redeem bonds or buy back shares.
- It protects businesses from large cash outflows by allowing sinking fund funds to use to pay off large amounts of debt.
- This gives a sense of confidence to investors and brings in more investors to put their money in the company’s bonds as there is a certain level of protection for them where the sinking fund maintain.
- It protects investors from default so that the bonds can offer at lower interest rates. It can be challenging to attract investors to companies with poor credit ratings expected to provide higher interest rates than the market rate.
How Does It Work?
It creates specific future needs by setting aside funds periodically. It is more like saving for planned cash outflow in the future. This aids companies in debt repayment by allowing them to use money from the sinking fund to settle debts.
Examples of the Sinking Fund
X Corp issues $1,000,000 worth of bonds with a maturity period of 10 years. Knowing the future repayment period X Corp creates a sinking fund and deposits $100,000 yearly to ensure the company has sufficient funds to pay the bondholders on maturity.
In the given case, considering X Corp has a newly established company that doesn’t have a high credit rating, they expected to pay a higher interest rate than the market average rate. The sinking funds created by X Corp help them issue bonds at the market interest rate.
Types of Sinking Funds
Below are different types of sinking funds:
- Specific Purpose Sinking Fund: This creates for a specific purpose and will utilize only for that particular purpose. (e.g., repayment to bondholders on maturity, settlement of long-term debts, etc.)
- Callable Bond Sinking Fund is specifically created to pay for callable bonds. Funds accumulate to pay for the bondholders at a specific call price.
- Purchase Back Sinking Fund: Sinking fund creates to use to purchase back the bonds from the bondholders. Bonds can be bought back at two prices; one is the market price, and the other is the sinking fund price.
- Regular Payment Sinking Fund: It creates the standard required payments.
Uses
- It can use to repurchase some outstanding bonds trading in the open market.
- The company’s credit rating decides on the basis of the honored financial commitment. It utilizes for the timely repayment of debts, improving the company’s rating.
- It uses to pay for the liabilities of the company to settle in the future.
- This can use to redeem bonds and buy back shares by the company.
- This fund saves for specific purposes and is predominantly used to pay off debts on time.
Advantages
Below are some of the advantages:
- It helps the companies accumulate the required funds to repay debts on maturity, as paying a considerable sum of money at a time is tough.
- Bonds backed by the sinking fund are lower risk than those supported by the collateral.
- If enough funds accumulate in sinking funds, it helps companies call off the bond even before maturity so the future interest cost can save, and it can improve the bottom line.
- It is a security to investors who put money in the company’s bonds, as the issuing company will not default on the payments if the sinking fund maintains the debt repayment.
- Timely debt settlement increases goodwill, attracts investors, and fosters trust, enhancing the company’s reputation and credibility.
Disadvantages
Some of the disadvantages are given below:
- Repurchase of Bonds before maturity using a sinking fund, and the investor loses the interest income for the rest of the period.
- Companies use the sinking fund to buy back bonds from the market when the market is low (i.e.) when bonds are trading at a discount or par value), which may be a loss to investors.
- When sufficiently sinking funds back a company, it is to the company’s advantage, and not much to investors gain, and they may lose interest in that investment due to uncertainty.
Conclusion
It is a pool of money set aside periodically to fund the cash outflow of long-term debt repayment. This mechanism is helpful to companies to make the required funds available at the time of maturity of bonds or other long-term debts. It helps in timely repayment and protects the company’s and investors’ interests.
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This is a guide to Sinking Fund. Here we also discuss the introduction and types of sinking funds with their advantages and disadvantages. You may also have a look at the following articles to learn more –
