Sinkable Bond: Definition, How It Works, Example

what is a bond sinking fund

It can be argued that this is not necessarily a disadvantage as the money in a sinking fund is used to pay off the debt that was raised to facilitate the needs of the business, so a sinking fund is just a measure to prudently manage finances. SmartAsset Advisors, LLC (“SmartAsset”), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S. Whether it’s $10,000 on a student loan or $10 million on a bond, spending a large amount of money at once can create problems.

Tips for Handling Debt

what is a bond sinking fund

A sinking fund is an account set up in order to pay off a debt or large purchase. A sinking fund is a type of fund, account or investment set up to repay a loan. It is often used by corporations preparing to pay a bond or in advance of a major purchase like a stock buyback or a strategic acquisition. Sinking funds are also used by individuals preparing to pay off significant debts, such as university loans, or to make large purchases. The corporation will report the bond sinking fund balance in the investments section of its balance sheet. The enhanced repayment protection offered by the sinking funds is attractive to investors seeking a safe investment.

Understanding a Sinking Fund Call

In addition to their own deposits, the fund grows with the market, compounding any gains. In 1772, the nonconformist minister Richard Price published a pamphlet on methods of reducing the national debt. The pamphlet caught the interest of William Pitt the Younger, who drafted a proposal to reform the Sinking Fund in 1786. Lord North recommended “the Creation of a Fund, to be appropriated, and invariably applied, under proper Direction, in the gradual Diminution of the Debt”.

What Is a Sinkable Bond?

what is a bond sinking fund

The bonds would likely pay interest payments (called coupon payments) to their owners each year. In the bond issue’s final year, CTC would need to pay the final round of coupon payments and also repay the entire $1,000 principal amount of each bond outstanding. After all, the company may be in good shape today, but it is difficult to predict how much spare cash a company will have in 10 years’ time. For example, let’s say Cory’s Tequila Company (CTC) sells a bond issue with a $1,000 face value and a 10-year life span.

Sinking funds are also popular for individuals even though, aside from some mortgages, few forms of individual debt penalize early payment. Paying an additional $1,000 per year to the Department of Education might make sound financial sense, but it can leave personal finances far tighter than many people prefer. Potential investors are requiring that ABC establish a bond sinking fund into which ABC will make annual deposits of $500,000. An independent trustee will invest the corporation’s annual deposits with the goal of the sinking fund balance growing to approximately $20 million by the time the bonds come due in 20 years.

However, investors may have concerns over the bonds being redeemed before maturity, as they will lose out on interest income. A sinking fund call is a provision that allows a bond issuer to buy back its outstanding bonds before their maturity date at a pre-set price. Similar in concept to a sinking fund for a corporation that issues and repays bonds, a sinking fund for household finances involves setting aside a certain amount of money each month to help pay off debts or to finance large purchases in the future. The idea is that by consistently saving relatively small amounts of money, there will eventually be enough stored up to spend toward something more significant.

  1. Corporate entities will also use sinking funds, often, to enhance the creditworthiness of bond issuance.
  2. A sinking fund is a type of fund, account or investment set up to repay a loan.
  3. The corporation saves $120,000 in interest payments in the first year and additional money thereafter.
  4. A company looking to pay a debt may set aside money on a periodic basis in an account specifically designated for that purpose.
  5. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.

Since there will be funds set aside to pay off the bonds at maturity, there’s less likelihood of default on the money owed at maturity. Also, if interest rates decrease, which would result in higher bond prices, the face value of the bonds would be lower than current market prices. In this case, the bonds could be called by the company that redeems the bonds from investors at face value. The investors would lose some of their interest payments, resulting in less long-term income.

Companies are required to disclose their sinkable bond obligations through their corporate financial statements and prospectus. However, sinking funds have the potential to depreciate given that they can underperform in a slow economy. We do not manage client funds or hold custody of assets, we accounting scandals help users connect with relevant financial advisors. This is particularly true for personal finance, where margins of error can be far thinner than in a well-funded corporate entity. To prepare for this the couple opens up a portfolio in which they buy a series of market-indexed mutual funds.

If interest rates decline after the bond’s issue, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate. If the bonds issued are callable, it means the company can retire or pay off a portion of the bonds early using the sinking fund when it makes financial sense. The bonds are embedded with a call option giving the issuer the right to “call” or buy back the bonds.

As an investor, you need to understand the implications a sinking fund can have on your bond returns. Sinking fund provisions usually allow the company to repurchase its bonds periodically and at a specified sinking fund price (usually the bonds’ par value) or the prevailing current market price. A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. The sinking fund provision is really just a pool of money set aside by a corporation to help repay previous issues and keep it more financially stable as it sells bonds to investors. A bond sinking fund is an escrow account into which a company places cash that it will eventually use to retire a bond liability that it had previously issued. The escrow account is administered by an independent trustee, which is also responsible for investing the funds within a specific set of predetermined investment criteria, as well as for redeeming bonds under the terms of the bond agreement.

As a result, it’s common to keep current with interest payments and put that money into a sinking fund. The cash is there in case of an emergency, but is otherwise walled off and set aside for a specific debt payment. The corporation is required to make regular deposits into the bond sinking fund, which is likely managed by an independent trustee.

The business creates a $20 million sinking fund and a call schedule for the next 20 years. On the anniversary date of each bond being issued, the company withdraws $1 million from the sinking fund and calls 5% of its bonds. The disadvantage of a sinking fund is that it limits the availability of cash on hand for a business.

Typically, bond agreements (called indentures) require a company to make periodic interest payments to bondholders throughout the life of the bond, and then repay the principal amount of the bond at the end of the bond’s lifespan. One way would be to increase the amount you pay or the frequency of your payments. However, a second way would be to place your payments into a fund dedicated to paying off the debt once the fund is full. Consider working with a financial advisor to make sure you are handling your debts in the most prudent and effective way. In North America and elsewhere where it is common for government entities and private corporations to raise funds through the issue of bonds, the term is normally used in this context.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.