Sinking Fund Bond Financing Programs
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.
Overview
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.[1] 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.
Characteristics
- Specific sinking fund – Sinking funds established for a specific issue
- Aggregate sinking fund – Sinking funds established for a range of bonds
- The structure of a sinking fund enables an issuer to execute a series of limited calls prior to maturity
- Bonds trading at a discount are repurchased by the company in the market
- Bonds are repurchased at par when bonds trade above the face value[2]
- Payments are typically made to a sinking fund trustee or trust company
- Failure to make sinking fund payments entitles the bondholder with similar legal rights as interest payment defaults.
Sinking Fund Provision
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.[3] 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.
Benefits
- Bondholders benefit from a sinking fund provision. Retiring a certain amount of the bond issue on an annual basis can reduce the payments made at the maturity of the bond.
- Reduces the risk of default to the investor since the maturity is shortened.
- Reduces credit risk since the fund is an implication to investors that provision to repay the debt has been secured.2 Investors perceive companies as favorable and credible when they reserve cash for potential liabilities associated with company assets.
- The scheduled payments help the issuer distribute the costs to redeem the bond over the life of the bond.[4]
- Companies have flexibility to manage their outstanding debt. For example, companies can gain when interest rates fall and can redeem the fund to reissue new bonds at lower interest rates. Ultimately, companies capitalize on low interest rate environments to reduce their financing costs and increase their cash flow.
Disadvantages
- The transference of cash to the sinking fund can limit the cash flow of the company. The company many not have sufficient funds to pay dividends to stockholders.
- Interest rate decrease negatively impacts investors since they may receive a sinking-fund call at a price that is below par and lower than current bond prices.
- Purchasing bonds at a premium to face value may affect investors when the sinking fund is called.
- Sinking funds have the potential to depreciate. Companies that invest in sinking funds place sinking funds at risk since they can underperform in a slow economy. [5]
Conclusion
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.
Sources
[1] JERRY J. WEYGANDT, PAUL D. KIMMEL & DONALD E. KIESO, FINANCIAL & MANAGERIAL ACCOUNTING, (2015).
[2] MOORAD CHOUDHRY, BOND AND MONEY MARKETS: STRATEGY, TRADING, ANALYSIS, (2003).
[3] JEFF MADURA. FINANCIAL MARKETS AND INSTITUTIONS, ABRIDGED EDITION, (2012).
[4] NEIL O’HARA, THE FUNDAMENTALS OF MUNICIPAL BONDS, (2011).
[5] Hildy Richelson & Stan Richelson, What Bond Calls Mean for Your Cash Flow, American Association of Individual Investors, (2016).
Jenn Abban contributed to this article.
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