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 in on the maturity date, and for that purpose, they set aside funds in sinking funds for future repayment. The money which has been 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, to meet specific long-term needs of money. When a company raises debt in the form of bonds, debentures, etc., it also knows the repayment and maturity period, and it is tough for any company to settle a large sum of money at the maturity period, so the concept of the sinking fund is followed where a sum is set aside and accumulated in the fund over the years keeping in mind the future repayment.
Bonds can sometimes have a provision where it can be even 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 easier.
- It is a pool of money saved every year that can be used for the redemption of bonds or buyback of shares.
- It helps the companies from a high cash outflow as the funds from the sinking fund can be utilized for a payout of a huge sum of debts.
- 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 the bonds can be offered at lower interest rates as it can be difficult to attract investors for companies which have a poor credit rating and they are expected to offer higher interest rate than the market rate.
How does It Work?
It is created by setting aside some funds periodically to address the specific needs in the future. It is more like saving for planned cash outflow in the future. It helps companies at the time of repayment as they can utilize the money from the sinking fund for settling the 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 every year to ensure that the company has sufficient funds to pay the bondholders on maturity.
In the given case, Considering X Corp has a newly established company, and it doesn’t have a high credit rating, so they are expected to pay a higher interest rate than the market average rate. Considering the sinking fund created by X Corp, it helps them to issue bonds at the market interest rate.
Types of the Sinking Fund
Different types are mentioned below:
- Specific Purpose Sinking Fund: In this, it is created for a specific purpose, and it 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 the 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 regular 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 financial commitment being honoured. The sinking fund is used for 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 for the redemption of bonds and the buyback of shares by the company.
- It is a fund saved for a specific purpose and predominantly used to pay off the debts on time.
Some of the advantages are given below:
- It helps the companies for accumulating the required funds for repayment of debts on maturity as it is tough to pay a huge sum of money at a time.
- Bonds backed by the sinking fund are low risk compared to other bonds as there are backed 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 bonds of the company 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:
- By using a sinking fund, bonds are bought back before maturity, and the investor loses the interest income for the rest of the period.
- Companies used the sinking fund to buy back bonds from the market when the market is at low (i.e.) when bonds are trading at a discount or par value, so this may be a loss to investors.
- When sufficient sinking funds back a company, it is to the advantage of the company 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 to protect the interests of the company as well as investors.
This is a guide to Sinking Fund. Here we also discuss the introduction and types of sinking fund along with advantages and disadvantages. You may also have a look at the following articles to learn more –