What is a Sinking Fund?
Sinking funds are nothing but a fund or merely a part of a preferred stock or bond indenture that is set aside at periodic intervals by companies for gradually repaying debt or replacing a wasting asset at a later date and these acts as a great tool that allows an organization to accomplish its predetermined goals and objectives.
Explanation
If you have ever seen a company issuing bonds, you may have known about sinking fund provision. To understand this, let’s take a simple sinking fund example of how we plan to purchase something at the end of a year.
- Let’s say that Tom wants to buy a TV at the end of the year. After talking to his wife Terry, he decides to create a separate savings account and put aside a particular amount every month to have the money saved for his big purchase at the end of the year.
- At the end of the year, Tom finds out that by saving his money every month, he gathered enough money to buy his dream TV.
It works in a similar manner. The company may have a purpose to buy back a portion of the bonds issued to reduce the outstanding amount, or they may need to buy new machinery that would produce more products for the company. That’s why the company creates a separate fund and set aside a particular amount each month to reach their target. And they call it the “sinking fund method.”
Why Companies Create a Sinking Fund Provision?
Here are the most important reasons for which a company creates this fund –
#1 – Having a sinking fund provision along with the issuance of bonds, makes the bonds more attractive:
The buyers of the bond want one thing – to get paid the principal plus the interest from the bonds. And if the company can reduce the risk from the investment, what more the bond buyers can ask for. By creating a separate sinking fund provision, the company ensures that the company will not default at the time of maturity, and as a result, the bond buyers would get their money back with interest.
#2 – Creating a sinking fund provision reduces the burden of the company at the time of maturity:
The company doesn’t worry about the interest they need to pay every period since the amount is quite meager in comparison with the principal amount. The actual issue is the lump-sum principal amount. By any cost, the company wants to reduce the principal amount. By creating this fund, the company can buy back a certain portion of the issued bonds at every period, and during maturity, they can reduce the principal amount by half or more.
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#3 – Creating a sinking fund provision can help the company reduce the fixed interest rate:
Since the company is taking responsibility for creating this fund for paying off the debt and reducing credit risks for the bond buyers, the company gets into the position of negotiating the interest rate to a certain extent. As a result, the company also can reduce the interest charges they need to pay along with the reduction in the principal amount.
#4 – The call feature of the sinking fund attached to the bond issued:
When the bond reduces the credit risk of the bond buyers, the market interest may get reduced. As a result, the bond value would increase. Since the amount of payments is fixed to the bond buyers, the reduction in market interest rate may increase the value of the bond. In that scenario, the call feature of the sinking fund provision helps the company in taking the driver’s seat. The call feature allows the company to buy back the bond at face value or at the par value. As a result, the company can buy back the bonds at the price they want, even if there’s a factorial change in the market.
#5 – Buying new machinery without breaking the bank:
A company may also create this fund for a huge future expense, like buying machinery. The company may create a separate fund and put in a particular amount every month or year and then, at the end of a particular period, can buy the machinery the company needed in the first place.
How does a Sinking Fund work in Bonds?
Let’s take a simple sinking fund example to see how it works.
Let’s say that company P&R has issued 100 bond certificates at $1000 per bond at 5% fixed interest payments every year for the next 10 years. They have also mentioned that they would be creating this fund to ensure that the credit risk gets reduced to a certain extent. And they have also mentioned that they can buy back the bond certificates at face value before maturity.
- Company P&R isn’t worried about the interest payments because it’s $5,000 every year. What they worry about rather is the principal amount.
- Hence, as mentioned, the company P&R decides to create a sinking fund provision of $5,000 each year, and it also decides to repurchase 5 bond certificates every year at face value.
- As a result, at the time of maturity (after 10 years), company P&R would be able to buy back $50,000 worth of bond certificates, and the principal amount would only be =($100,000 – $50,000) = $50,000.
Warning for the Bond Buyers
- It’s always advisable to do your own due diligence before you ever purchase bonds issued by a company. You should look at different aspects and whether or not any sinking fund provision is attached to the issued bonds.
- Since this fund and call feature to give the company the upper hand, it’s better to read the terms and conditions before purchasing the bond certificates.
Conclusion
This is a good option for a company when they want to ensure that the principal amount gets significantly reduced. It may also seem that the credit risk for the bond buyers would get drastically reduced. However, the buyers should always check whether there’s any exploitative terms & conditions and if there’s any, avoid that particular bond by all means.
The bond certificates should be transparent and should be a win-win for both the parties involved. If it’s just created to benefit the company, the bond buyers should go for something else. After all, there’s no shortage of good investment opportunities in the market.
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Recommended Articles
This has been a guide to what are sinking funds? Here we discuss how it works in bonds along with examples. Here we also discuss the reasons why companies create sinking fund provisions. You may learn more about fixed income from the following articles –
