Bond Sinking Fund

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.

Explanation

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 BondsIssuance Of BondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more by creating such Bond Sinking Fund.

Bond Sinking Fund

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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.

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 riskGreater Interest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more 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

Advantages

 Disadvantages

  • 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 AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more 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.

Conclusion

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 –

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