Introduction of Sinking Fund
A sinking fund is a fund that is earmarked for a specific purpose, like to pay off the debts to be settled in the future, to make 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 be used for its specific purpose.
It is a fund set aside to settle the debts of the company to be repaid in the future, to fund the planned capital expenditure, and meet specific long-term needs of money. 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 of money at maturity, so the sinking fund concept is used, in which a sum is 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 are maintained for repayment of debts, but sometimes it is also used for buyback (I.e.) repurchasing the shares or bonds issued by the company.
Objectives of the Sinking Fund
- It is maintained to reduce the risk of funds being short at the time of repayment of debts. It 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 be used to pay off large amounts of debt.
- It gives a sense of confidence to investors and brings in more investors to put their money in the bonds of the company as there is a certain level of protection for them where the sinking fund is maintained.
- It protects investors from the default so that the bonds can be offered at lower interest rates. It can be challenging to attract investors to companies with poor credit ratings that are expected to provide higher interest rates than the market rate.
How does It Work?
It is created by setting aside some funds periodically to address specific needs in the future. It is more like saving for planned cash outflow in the future. It 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 Fund
Different types are mentioned below:
- Specific Purpose Sinking Fund: This is created for a specific purpose and will be utilized only for that particular purpose. (e.g., repayment to bondholders on maturity, settlement of long-term debts, etc.)
- Callable Bond Sinking Fund: It is specifically created to pay for callable bonds. Funds are accumulated to pay for the bondholders at a specific call price.
- Purchase Back Sinking Fund: This sinking fund is explicitly created 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 is created to pay for the standard required payments.
- It can be utilized to repurchase a portion of outstanding bonds trading in the open market.
- The company’s credit rating is decided based on the honored financial commitment. It is used for the timely repayment of debts and helps the company’s rating be improved.
- It is used to pay for the liabilities of the company to be settled in the future.
- It can be used to redeem bonds and buy back shares by the company.
- It is a fund saved for a specific purpose and predominantly used to pay off debts on time.
Some of the advantages are given below:
- 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 low risk compared to other bonds as there are supported by the collateral.
- If enough funds are accumulated in sinking funds, it helps companies call off the bond even before maturity so the future interest cost can be saved, and it can improve the bottom line.
- It acts as 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 is maintained for the debt repayment.
- It increases the company’s goodwill by settling the debts on time, and it helps to attract more investors and get their trust.
Some of the disadvantages are given below:
- Bonds are repurchased 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.
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.
This is a guide to Sinking Fund. Here we also discuss the introduction and types of sinking fund with their advantages and disadvantages. You may also have a look at the following articles to learn more –