Sinking Fund Definition

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Sinking Fund Definition

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.

A Little More on What is a Sinking Fund

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 bond’s 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.

References for Sinking fund

Academic Research on Sinking fund

The call, sinking fund, and term-to-maturity features of corporate bonds: an empirical investigation, Mitchell, K. (1991). The call, sinking fund, and term-to-maturity features of corporate bonds: an empirical investigation. Journal of Financial and Quantitative Analysis, 26(2), 201-222. This paper presents an empirical investigation of Sinking Funds in relation with the maturity term of corporate bonds.

A strategic analysis of sinking fund bonds, Dunn, K. B., & Spatt, C. S. (1984). A strategic analysis of sinking fund bonds. Journal of Financial Economics, 13(3), 399-423. This paper analyses the Sinking Fund Bonds in terms of pricing, distribution, ownership, and more.

The value of corporate debt with a sinkingfund provision, Ho, T., & Singer, R. F. (1984). The value of corporate debt with a sinking-fund provision. Journal of Business, 315-336. This paper studies the valuation of corporate debts vis-a-vis the provision of Sinking Fund.

Information asymmetry and the sinking fund provision, Wu, C. (1993). Information asymmetry and the sinking fund provision. Journal of Financial and Quantitative Analysis, 28(3), 399-416. This paper studies the implication of asymmetric information on the amortization of Sinking Funds.

Richard Price and Pitt’s sinking fund of 1786, Cone, C. B. (1951). Richard Price and Pitt’s sinking fund of 1786. The Economic History Review, 4(2), 243-251. This chapter discusses British Prime Minister Pitt’s Sinking Fund of 1978, based on the ideas of Dr. Price.

Imputed yields of a sinking fund bond and the term structure of interest rates, Jen, F. C., & Wert, J. E. (1966). Imputed yields of a sinking fund bond and the term structure of interest rates. The Journal of Finance, 21(4), 697-713. This paper studies the yield statistics on corporate bonds as Sinking Funds, differentiating between imputed yield, true yield, and yield as calculated in various bond structures.

Changes in the Interests of Classes of Stockholders by Corporate Charter Amendments Reducing Capital and Altering Redemption Liquidation and Sinking Fund, Becht, A. C. (1950). Changes in the Interests of Classes of Stockholders by Corporate Charter Amendments Reducing Capital and Altering Redemption Liquidation and Sinking Fund Provisions. Cornell LQ, 36, 1. This paper takes a look at the different classes of stocks like preferred stocks and common stocks that make up the capital structure of corporates and their influence on Sinking Funds.

The Limits of Section 103 (c): Municipal Bond Arbitrage After the Invested Sinking Fund, Peaslee, J. M. (1978). The Limits of Section 103 (c): Municipal Bond Arbitrage After the Invested Sinking Fund. Tax L. Rev., 34, 421.

Sinking fund preferred stock, McDaniel, W. R. (1984). Sinking fund preferred stock. Financial Management, 45-52. This paper analyses the yield differentials in preferred stock Sinking Funds.

A rationale for the sinkingfund provision in a quasicompetitive corporate-bond market, Ogden, J. P. (1988). A rationale for the sinking-fund provision in a quasicompetitive corporate-bond market. Journal of Business Research, 16(3), 197-208. This paper evaluates the effect of Sinking Funds on corporate bonds under three different market regimes.

Should you stop investing in a sinking fund when it is sinking?, Mingers, J., & Parker, K. T. (2010). Should you stop investing in a sinking fund when it is sinking?. European Journal of Operational Research, 207(1), 508-513. This article discusses Sinking Funds and investing in one when its on the cusp of collapse.

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