What is a Sinking Fund?

A sum of money set aside periodically to create a fund that covers debt repayment for money borrowed on bonds, is called the Sinking Fund. It reduces the difficulties in managing payments for large outlays once the bonds have matured.

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How Does a Sinking Fund Work?

Investors use Sinking Funds as a safeguard against corporate bond issues as the longer they are held, the greater the interest risk associated with them. The possibility of defaulting on payments on bonds maturation decreases as the amount of final payment goes down. Sinking Funds can be maintained in the forms of cash, preferred stocks, or bonds. Trustees draw on random serial numbers to call on bonds when the issuer deposits cash. Usually, the bonds issue price is used as call price. The call price value gets closer to par value as the bond nears maturity. If the issuer had deposited other debts instead of cash in the account, he buys them back, especially when they're trading below par in the market.

Creating a Sinking Fund

Issuers create a custodial account and make periodic deposits into this account to establish a Sinking Fund. Payments follow a set pattern, might begin a few years after the establishment of the account, and are mostly uniform in value unless otherwise specified based on change in revenues or other special provisions. With the exception of Preferred Stocks used in Sinking Funds, any failures to deposit the scheduled amount in the account is considered as defaulting on payments.

Pros and Cons of a Sinking Fund

Pros:

1. Facilitates lower interest rates for borrowed money as it improves creditworthiness score of the company.
2. Improves investor confidence in the company, proving helpful in raising more capital.
3. Tax benefits save a lot of money that can be diverted to solve cash flow and other financial problems.
4. Tax sops can also be accrued on the interest being paid to investors.
5. Money saved can be used to add to the Sinking Fund to cover other operational expenses.
6. Drives down the possibility of defaulting on outstanding loans as the company is in complete control of its expenses.

Cons:

1. Rate of interest on borrowed money is inversely proportional to bond prices. If bonds are called at higher rates, investors stand to lose their money.
2. The opportunity cost of locking in money with one firm is another reason for investors to reconsider Sinking Funds.