What is sinking fund?
What is sinking fund?
A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. A company that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship of a large outlay of revenue. A sinking fund is established so the company can contribute to the fund in the years leading up to the bond's maturity.
A sinking fund is a type of fund that is created and set up purposely for repaying debt. The owner of the account sets aside a certain amount of money regularly and uses it only for a specific purpose. Often, it is used by corporations for bonds and deposits money to buy back issued bonds or parts of bonds before the maturity date arrives. It is also one way of enticing investors because the fund helps convince them that the issuer will not default on their payments.
Basically, the sinking fund is created to make paying off debt easier and to ensure that a default won't happen because there is a sufficient amount of money available to repay the debt. Though most bonds take several years to mature, it is always easier and more convenient to be able to reduce the principal amount long before it matures, consequently lowering credit risk.
Advantages of sinking funds
a) Brings in investors
b) The possibility of lower interest rates
c) Stable finances
History
The sinking fund was used in Great Britain in the 18th century to reduce the national debt. While used by Robert Walpole in 1716 and effectively in the 1720s and early 1730s, it originated in the commercial tax syndicates of the Italian peninsula of the 14th century, where its function was to retire redeemable public debt of those cities.
Sinking Fund types
Sinking fund may operate in one or more of the following ways:
- The firm may repurchase a fraction of the outstanding bonds in the open market each year.
- The firm may repurchase a fraction of outstanding bonds at a special call price associated with the sinking fund provision.
- The firm has the option to repurchase the bonds at either the market price or the sinking fund price, whichever is lower.
- A less common provision is to call for periodic payments to a trustee, with the payments invested so that the accumulated sum can be used for retirement of the entire issue at maturity.
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