What is Bond Sinking Fund?
A bond sinking fund is merely a fund that is set aside by a company for the purpose of paying off a bond or future debt obligation and it was established in order to allow the company to make a contribution towards the funds for the years until bond’s maturity date.
It is basically an Escrow Account that is maintained by the company for the exclusive purpose of retiring the bond issued by it, and the company places cash in the same at specified periods, and this account is managed and administered by an Independent Trustee.
As such many companies with less than desirable credit ratings raise money through the issuance of Bonds by creating such Bond Sinking Fund.
- It requires the Issuer (i.e., the company which is 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, 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 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 seen as relatively riskier, and as such, the investors who wish to subscribe to the Bond Issue of such Issuers need extra incentive and also a safety cushion to avoid the risk of default.
- Also, it acts as a security for the Investor that in the unlikely event issuer fails to repay or default in repayment, Investor can get there some portion of their funds (if not all) from the Bond Sinking Fund, which is managed by Example.
Let’s understand the same with the help of an example:
ABC Company sells a Bond Issue with a $100 face value and 5 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 coupon payment of $5 per year and will have to repay the entire $100 on maturity.
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In order to avoid any cash flow problem that may arise on account of repayment of the entire principal amount at the end of 5 years 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 redeem on account of maturity.
Why Bond Sinking Fund?
Bonds are usually issued for a longer time frame and pose greater interest rate risk and also risk arising on account of default in repayment of the principal amount on maturity due to strain in the financial health of the company. It acts as a cushion for both the issuer as it results 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 of the Market price
- Repurchase of Bonds at maturity
- 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 perspective, it can result in booking Capital gains if Bonds are purchased in the open market below Book Value due to market conditions.
- Bonds with Sinking Fund results 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 long-term debt needed for profitable long-term gestation projects.
Accounting Treatment of Bond Sinking Fund
It is a long-term asset that is created solely for the purpose of retiring bonds. 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 led to improved Current Assets and resulting Current Ratio, which may not be the case.
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 offering by the Issuer on account of the safety offered. Further, this Sinking fund requires upfront pledging of assets in the Fund or uniform annual payments or contributions into the fund, which is administered by an Independent Trustee. Thus it is a tradeoff between safety and profitability from an Investor’s perspective and more attractive to risk-averse investors. On the contrary, money set aside in Bond Sinking Fund by the Issuer is not available for the growth of the company or for payment of dividends, which directly impacts the Issuer Company’s Stockholders adversely.
Bond Sinking Fund Video
This has been a guide to what is Bond Sinking Fund. Here we discuss its definition, advantages, disadvantages, and accounting treatment of Bond Sinking Fund along with practical examples. You can learn more about Fixed Income from the following articles –