Bond Sinking Fund

A bond sinking fund is merely a fund set aside by a company to pay off a bond or future debt obligation. It allows the company to contribute towards the funds until the bond's maturity date. Thus, it is a trade-off between safety and profitability from an Investor's perspective and is more attractive to risk-averse investors.

Bond sinking fund provisions are governed by the terms and conditions of the Bond Agreement and act as a source of safety for the investors of such Bond Issuance. It also results in a lower interest rate the Issuer offers on the safety offered. The money set aside in these funds by the Issuer is not available for the company's growth or payment of dividends.

A bond sinking fund is an Escrow Account maintained by the company for the exclusive purpose of retiring the bond issued, and the company places cash in the same at specified periods. This account is managed and administered by an Independent Trustee.

Many such companies with less than desirable credit ratings raise money through the issuance of Bonds by creating such a Bond Sinking Fund.

• It requires the Issuer (i.e., the company raising funds) to set aside money periodically for the exclusive purpose of redeeming or buying back the specific Bonds for which the fund has been created.
• The issuer is required to make a deposit/ contribution in the bond sinking fund account, which is managed by an Independent Trustee who is responsible for the management of the Fund, investment of funds with predetermined specific investment criteria, and is also entrusted with the responsibility to ensure that this fund is used only for the purpose for which it is formed.
• It acts as collateral and makes sense in the case of Issuers, who are considered relatively riskier. As such, the investors who wish to subscribe to the Bond Issue of such Issuers need extra incentives and a safety cushion to avoid the risk of default.
• Also, it acts as a security for the Investor in the unlikely event the issuer fails to repay or defaults in repayment. The Investor can get some portion of their funds (if not all) from the Bond Sinking Fund, which is managed by Example.

A bond sinking fund provision serves a crucial purpose in the world of finance and investment. Its primary function is to ensure that a company or issuer of bonds can meet its future debt obligations and provide a level of security to bondholders. Here's why creating a bond sinking fund is essential:

• Debt Reduction and Security: The fundamental purpose of a sinking fund is to set aside money regularly to retire or redeem bonds when they mature. This reduces the outstanding debt load on the issuer, making it financially sound and instilling confidence in bondholders.
• Risk Mitigation: By earmarking funds specifically for bond repayment, an issuer can mitigate default risk. It assures investors that there will be funds available to honor their bonds, reducing the perceived risk associated with the investment.
• Lower Borrowing Costs: Knowing that there is a sinking fund in place can lower the interest rates at which the issuer can borrow money. Lenders are more willing to offer favorable terms when they see responsible financial management.
• Investor Attraction: A sinking fund can make bonds more attractive to investors by providing a safety net. This, in turn, can lead to higher demand for the bonds, potentially resulting in lower interest costs for the issuer.
• Steady Cash Flow Management: The regular contributions to the sinking fund ensure that the issuer has the necessary funds available when the bonds mature. This prevents financial strain and allows for effective cash flow management.

Bond sinking funds are classified into various types, each designed to meet specific financial objectives. Here are the primary classifications of bond sinking funds account:

• Serial Sinking Fund:
  • This type of fund is designed to retire a portion of the bond issue in installments or "serials" over time.
  • It is commonly used for larger bond issues with staggered maturities, ensuring that the issuer steadily reduces its debt burden.
• Term Sinking Fund:
  • A term sinking fund aims to retire the entire bond issue on a specific maturity date.
  • It is well-suited for bond issues with a fixed maturity schedule, aligning the fund's objective with the bonds' maturity.
• Revolver Sinking Fund:
  • A revolver sinking fund allows the issuer to repurchase bonds on the open market.
  • This type offers flexibility, as the issuer can buy back bonds when market conditions are favorable, potentially reducing borrowing costs.
• Level Debt Service Sinking Fund:
  • With this approach, the issuer contributes a constant amount to the sinking fund each year.
  • It helps ensure that the issuer can meet its bond repayment obligations without experiencing significant fluctuations in contributions.
• Cash Sinking Fund:
  • In a cash-sinking fund, the issuer sets aside cash specifically for bond redemption.
  • This type offers simplicity and liquidity, as cash is readily available for bondholders upon maturity.
• Advance Refunding Sinking Fund:
  • This fund is created to retire existing bonds with the proceeds from a new bond issue.
  • It is a strategic tool for refinancing debt at more favorable terms or interest rates.

Now that we understand the basics, purpose, and classifications, let us apply the knowledge to practical application through the examples below.

Example #1

ABC Company sells a Bond Issue with a $100 face value and five years to maturity. The Bond carries a coupon of 5% and is redeemable at par value at the end of 5 years on its maturity. Accordingly, ABC Company will pay a coupon payment of $5 per year and will have to repay the entire $100 on maturity.

To avoid any cash flow problem that may arise on account of repayment of the entire principal amount at the end of 5 years of the Bond, the agreement requires ABC Company to create a Bond Sinking Fund and pledge specific assets to the fund, which will be exclusively available to pay off bonds at all times. Further, ABC Company is required to contribute a specified amount to the Bond Sinking Fund every year so that the company will face a smaller final cash outflow requirement at the end of 5 years when the bonds are due to be redeemed on account of maturity.

Example #2

Newfound Land Inc. is an energy company in the Canadian Providence of Newfoundland and Labrador. It is the primary energy supplier in the region with 275,000 accounts that benefit from their services.

In August 2023, Newfoundland Inc. announced the closing of their $90 million bond sinking fund at 5.122 percent which is due in August 2053. The net proceeds from the private placement of this fund will be used towards repaying short-term borrowings that the company incurred to fund its capital expenditures and general corporate practices.

Bonds are usually issued for a longer time frame and pose greater interest rate risk and risk arising on account of default in repayment of the principal amount on maturity due to strain on the company's financial health. It acts as a cushion for the issuer, resulting in a substantially lower amount required to discharge the principal repayment on maturity and the investor by acting as a safety cushion.

However, it is pertinent to note that not all Corporations raising funds through Bond Issue are required to create a Bond Sinking Fund; however, bonds with sinking funds are viewed as relatively less risky by the Investor community.

This Sinking Fund is governed by the terms of the Bond Agreement and helps the issuer in different ways in the repurchase of Bonds, such as:

• Periodic Repurchase of Bonds from the open market
• Periodic repurchase of Bonds at a specific call price or lower than the Market price
• Repurchase of Bonds at maturity

It is a long-term asset that is created solely to retire bonds. Moreover, It is reported in the Asset section of the Balance Sheet under the Long Term Asset Head within the Investment classification. It is not classified under Current Assets as that will result in misconception among investors regarding the usage of the Bond Sinking Fund and lead to improved Current Assets and resulting Current Ratio, which may not be the case.

The advantages of having a bond sinking fund provision are as discussed below.

• It reduces default risk for the Investor as it leaves less principal outstanding at the time of maturity for the Issuer Company, thereby reducing the chances of default for the Investor.
• From the Issuer perspective, Bond with the Sinking Fund is usually issued with lower coupon rates due to the additional safety cushion offered by the Issuer to Investor.
• From the Issuer's perspective, it can result in booking Capital gains if Bonds are purchased in the open market below Book Value due to market conditions.

Despite the various advantages, there are a few disadvantages of bond sinking fund accounts. Let us understand them through the points below.

• Bonds with Sinking Funds result in a limited upside for Investors due to the mandatory redemption associated with provisions of such funds.
• From an Issuer perspective, the opportunity cost of the Bond Sinking Fund requirement leads to the inability of the business to raise the long-term debt needed for profitable long-term gestation projects.