Investors have been attracted to sinking funds to raise capital, increase cash flow and reduce financing costs. The article will present an overview of the sinking fund including the characteristics of a bond sinking fund and the general provisions of a sinking fund. The article will also present a discussion of the benefits and drawbacks associated with investing in a sinking fund.
A sinking fund is a fund in which a firm makes consistent payments to ensure that there will be sufficient funds to repay the bondholders when the bond matures. This type of debt fund is used to secure specific assets in companies to redeem the bond at maturity. Many bonds with sinking fund clauses indicated in their indenture obligate the issuer to make scheduled payments into a fund or buy back a certain percentage of the bond issue during each specific period.
Bond indentures can include a sinking fund provision that requires the company to retire a specific amount of the bond issue each year or set-aside a certain portion of the initial funding in a special sinking fund account. Although, sinking fund provisions require yearly payments from the bond issue, the provisions of sinking funds can vary. For example, a bond with 15 years maturity could have a provision to annually retire ten percent of the bond issue or the requirement in the provision could be to retire ten percent of the bond issue at the beginning of the fifth year until maturity. The remaining amount is known as the balloon maturity.
Sinking fund assets have supported investors to reduce their cost of capital, minimize financing costs and increase cash flows. A sinking fund provides bondholders with an assurance that they will receive payments on the bond issue. Investors benefit from sinking funds since it reduces both credit and default risk, although, in low interest rate environments the call feature of the sinking fund places investors at a disadvantage. Nevertheless, issuers of sinking fund bonds can capitalize on low interest rate environments to call the bonds and reissue new bonds to reduce financing costs.
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 JEFF MADURA. FINANCIAL MARKETS AND INSTITUTIONS, ABRIDGED EDITION, (2012).
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Jenn Abban contributed to this article.