Sinking Fund

A sinking fund is a way to pay back money borrowed through a bond issue by making regular payments to a trustee who retires part of the issue by buying the bonds on the open market. The sinking fund provision is actually just a sum of money saved by a company to assist pay off prior debts and maintain it more stable financially when it sells bonds to investors.

How Bond Repayment Works

Corporate bond arrangements, also known as indentures, sometimes call for a business to pay periodic interest to bondholders over the course of the bond's life and to repay the bond's principal amount at the conclusion of the bond's term.

Let's use the Cory's Tequila Company (CTC) as an example, which issues bonds with a $1,000 face value and a ten-year life. Each year, the bonds' owners would probably receive interest payments (also known as coupon payments). CTC would be required to pay the final round of coupon payments as well as the entire $1,000 principal of each outstanding bond during the final year of the bond issue.

This could be a concern because, while CTC might find it simple to afford the relatively tiny $50 coupon payments each year, paying back the $1,000 might be more difficult, particularly if CTC is having cash flow issues when the bonds are due. Even while the business may be doing well right now, it is hard to say how much cash it will have left over in 10 years.

Sinking Fund Bond Formula

It can be calculated using the following examples of the time value of money relationship:

Sinking Fund Bonds = A * [(1+r)n – 1 / r]

Here,

‘A’ stands for the regular contribution amount.

The symbol ‘r’ denotes the interest rate.

The number ‘n’ symbolizes the passage of time.

Types of Sinking Fund Bonds

Sinking Fund Bonds for Callable Bonds

The corporation callbacks its bonds by repurchasing them from the holders at a premium if interest rates drop. A sinking fund bond could assist the corporation in purchasing the bonds by giving it the necessary financial cushion.

Sinking Fund Bonds for Aligned Purpose and Goals

The company may have set up objectives and goals for which it may need to raise money in the future. The company might establish such a bond in the future to fulfill these objectives.

Sinking Fund Bonds for Buyback of Bonds

The company might try to pay off its debt sooner. To cater to this purpose, it may contain such a fund to cater to the buybacks of existing issued bonds from the holder of bonds.

Advantages

  1. Strategic usage of the sinking fund bonds can result in early debt and liability repayment.
  2. Also, it makes timely debt repayment possible on the due date.
  3. These bonds can be used to call back current debt offerings if interest rates decline. It can be used to repurchase current bond issues from the bondholders.
  4. Early loan repayment boosts the issuing company's reputation because of this.

Disadvantages

  1. Investors view the bond holder as losing out on interest payments because the bonds were paid off early using sinking bond proceeds.
  2. As the offerings were called back using sinking bond funds, the company might not be able to keep the faith of its current investors.

Conclusion

  • Companies that issue bonds keep a sinking fund, which is money set aside or saved to pay off a debt or bond.
  • Bonds issued with sinking funds have a lower yield as they carry because they are backed by the fund's collateral.
  • By the use of a sinking fund, debt can be paid off early, saving a business money on interest payments and strengthening its financial position.
  • Bonds with callable features may also be redeemed using sinking funds.
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