What is a Sinking Fund?
A sinking fund is a part of aindenture or charter that requires the to regularly set aside in a separate custodial account for the exclusive purpose of redeeming the or .
How does a Sinking Fund work?
To understand how a sinking fund works, let's assume Company XYZ 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 and is used exclusively to retire this debt. This strategy ensures that Company XYZ 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 go. The then makes payments to the of the custodial account. The sinking fund payments are usually fixed amounts, but some 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 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 or in the form of other bonds or preferred stock. If the issuer had made deposits, the then uses the to repurchase some or all of the bonds on the open . It does this by calling the bonds using a lottery system (that is, it draws random bond serial numbers). The is usually the 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 , this call price gets closer to .
If the issuer has instead deposited other debt into the custodial account, the issuer usually purchases the bonds itself on the open . 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 , 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 . 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 do Sinking Funds matter?
In general, sinking funds benefit investors in three ways. First, the redemptions leave less default risk. Second, if interest rates increase, thereby lowering prices, investors get some downside protection because the provision forces the to redeem at least some of those at the sinking-fund , which is usually , even if the are selling below at the time. Third, sinking fund provisions create liquidity for the in the secondary , which is especially good when interest rates are increasing and the bonds are less valuable -- the is in the 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 provisions, sinking fund provisions investors might have to reinvest their elsewhere at a lower rate. This is especially risky if the issuer exercises a doubling .
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.