Sinking Fund Bonds Definition
The sinking fund bonds are defined as the bonds wherein the bond issuer specifically keeps a set defined amount to repay the holders of the bonds on the date of maturity or predefined dates. It is basically a bond made by the issuer to be catered as collateral if in case the issuer defaults on its payments to the holders of the bonds at a defined future date. A company prepares an initial cash corpus, which then handover to the independent trustee.
The independent trustee would then use the amount received from the company to invest it further in assets having long-term maturity. Such investment may be broken only to retire existing issues of bonds.
Types of Sinking Fund Bonds
#1 – Sinking Fund Bonds for Callable Bonds
Whenever there is a decrease in rates of interest, the company callbacks it bonds by buying them back from the holders at a premium. A sinking fund bond may utilize to help the company in buying the bonds issued by providing the needful cash cushion for the company.
#2 – Sinking Fund Bonds for Aligned Purpose and Goals
The business may have incorporated certain goals and purposes for which it may require cash to service them in the future. The business may incorporate such a bond to service such goals in the upcoming future.
#3 – Sinking Fund Bonds for Buyback of Bonds
The business may look to retire its debt early. To cater to this goal, it may incorporate such a fund to cater to the buybacks of existing issued bonds from the holder of bonds.
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Sinking Fund Bond Formula
It can be determined using the time value of money relationship as described below:
Here,
- The amount contributed on a regular basis is represented by A.
- The rate of interest is represented by r.
- The time period is represented by n.
Examples of Sinking Bond Fund
Example #1 – Numerical Example
The company holds a debt of $1 million at the rate of interest of 6% and with a repayment period of 5 years. The company plans to incorporate a sinking fund of $60,000 at the end of 5 years, with the rate of interest as 4%. The company has to determine the periodic annual payments to formulate the sinking fund.
The Periodic amount would be determined as follows: –
- $60,000 = A * (1+0.04)^5 -1 /0.04
- $60,000 = A * (1+0.4)^5 -1 /0.04
- $60,000 = A * (1.2167 -1) /0.04
- $60,000 = A * (0.2167) /0.04
- $60,000 = A * 5.4163
- A = $60,000 / 5.4163 = $11,077.6
Therefore, the company must save annually $11,077.6 into the sinking account which could then be utilized in the early or easy payment of the bonds.
Example #2
Suppose the company has issued callable bonds of $20 million at the rate of interest of 8 percent for the time period of 10 years. There has been a decrease in the rate of interest by 2 percent, and the updated rate of interest is at 6 percent. The company additionally maintains a sinking fund bond of $5 million.
The company may call the bonds back only to reissue them at a lower rate of interest. The company may utilize the sinking fund bonds to repay the call premium that would be associated with the callable bonds.
Example #3 – Practical Application
Suppose the business has a debt worth of $10 million to be paid off at the rate of a 6% rate of interest after 10 years. The company additionally faces a risk of default as well as interest rate risk. To cater to such a situation and to handle their exposure, the company plans to incorporate a sinking fund bond wherein it plans to contribute $2 million annually for three years.
After the end of three years, the business would have $6 million to pay-off the remainder debt payable after then end of three years.
Advantages
- The sinking fund bonds, if used strategically, can be used to pay off debt and liabilities early.
- It also facilitates timely payments of debt obligations on the date of maturity.
- If the rates of interest decrease, then these bonds can be utilized to call back existing debt issues. It can be used to buy back existing bonds issues from the holders of the bonds.
- Since there are early payments of debts, it enhances the goodwill of the issuing business.
Disadvantages
- From the perspective of investors, the holder of the bonds loses on the interest payments since their bonds were paid off early using sinking bond funds.
- The business may not retain its existing investor confidence since the existing issues were called back using sinking bond funds.
Important Points
- The sinking bond funds are employed by the business that has a very low credit rating and bad credit profile.
- It is very risky for the investor to invest in such bonds as such bonds have high default risk.
- It may be used to buy back any pre-existing bonds present in the open market.
- They are normally classified as the restricted asset for the issuing business.
- In the balance sheet, sinking bond funds are recorded under the non-current asset section with account label as Investments.
- Although these bonds are composed only of cash, it is never a part of current assets as it has primarily been prepared to pay off the long-term debt and not current liabilities.
Conclusion
Sinking Fund bonds are made when the issuing company has to safeguard itself from interest rate risk and default risk. The sinking fund bonds are formed by the business, which is not cash-rich. Rather, they are cash deficient and have strained financial health. They are normally visualized as collateral for the holder of the debt, which would be used by them when the company defaults.
The business may incorporate this bond under the supervision of a trustee. The trustee is an independent member that would supervise the administration of such bonds. The trustee is required in such situations due to the larger size of sinking funds, and these funds have to be managed the system so that it could be used to redeem the debt early.
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