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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Sinking Fund

What it is:

A sinking fund is a part of a bond indenture or preferred stock charter that requires the issuer to regularly set money aside in a separate custodial account for the exclusive purpose of redeeming the bonds or shares.

How it works (Example):

To understand how a sinking fund works, let's assume Company XYZ issues $10 million of bonds that mature in 10 years. If the bonds have a sinking fund, Company XYZ might be required to retire, say, $1 million of the bonds each year for 10 years. To do so, Company XYZ must deposit $1 million each year into a sinking fund, which is separate from its operating funds and is used exclusively to retire this debt. This strategy ensures that Company XYZ will pay off the $10 million in 10 years.

Establishing a sinking fund is usually a matter of setting up a custodial account into which the sinking fund payments will go. The issuer then makes payments to the trustee of the custodial account. The sinking fund payments are usually fixed amounts, but some bond indentures allow for variable sinking fund provisions (usually based on earnings levels or other conditions). Sometimes the issuer does not have to begin setting aside sinking funds for several years. Regardless of the ultimate size and timing of the payments, failure to make the payments is usually deemed an act of default in bond indentures (although this is usually not the case for preferred stock issues with sinking funds).

In most cases, the sinking fund requires the issuer to actually retire a portion of the debt on a prearranged schedule so that all of the debt is retired by the maturity date. How this occurs depends on what is in the sinking fund account.

Usually, sinking funds can either be in cash or in the form of other bonds or preferred stock. If the issuer had made cash deposits, the trustee then uses the funds to repurchase some or all of the bonds on the open market. It does this by calling the bonds using a lottery system (that is, it draws random bond serial numbers). The call price is usually the issue price of the bond (that is, if the bonds were issued at par, then the call price is par; if the bonds were issued at a discount, then the call price equals that discounted price). As the bonds get closer to maturity, this call price gets closer to par value.

If the issuer has instead deposited other debt into the custodial account, the issuer usually purchases the bonds itself on the open market. This usually happens when the bonds are selling below par on the open market.

Sometimes a bond indenture with a sinking fund also has a doubling option, which allows the issuer to redeem twice the amount prescribed at each step in the sinking fund requirement.

Sometimes an issuer can establish one sinking fund for all of its bond issues rather than a separate sinking fund for each issue. The sinking fund payments are generally a percentage of all outstanding debt, and the issuer can apply the funds to one or more particular issues of its choice. These sinking funds are usually called aggregate sinking funds or blanket sinking funds.

Why it Matters:

In general, sinking funds benefit investors in three ways. First, the redemptions leave less principal outstanding, making final repayment more likely and thus lowering default risk. Second, if interest rates increase, thereby lowering bond prices, investors get some downside protection because the provision forces the issuer to redeem at least some of those bonds at the sinking-fund call price, which is usually par, even if the bonds are selling below par at the time. Third, sinking fund provisions create liquidity for the bond in the secondary market, which is especially good when interest rates are increasing and the bonds are less valuable -- the issuer is in the market as a buyer even when prices fall.

There are also some disadvantages, however. If rates increase, thereby increasing bond prices, investors may find their upside limited because the mandatory redemption associated with the sinking fund means they could receive the sinking-fund price for their bonds even if the bonds are selling for more than that on the open market. Also, like call provisions, sinking fund provisions mean investors might have to reinvest their money elsewhere at a lower rate. This is especially risky if the issuer exercises a doubling option.

For issuers, adding a sinking fund helps companies borrow cheaply and still satisfy investor desires for the maximum returns with minimum risk. For investors, the lower default risk and downside protection are why yields on bonds with sinking funds are often lower than yields of similar bonds without sinking funds.

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