WHAT IS A SINKING FUND?
A sinking fund is a part of a bond indenture or preferred stock charter that requires the issuer to regularly set money aside in a separate custodial account for the exclusive purpose of redeeming the bonds or shares.
let's assume company ABC issues $10 million of bonds that mature in 10 years.
If the bonds have a sinking fund, company ABC might be required to retire, say, $1 million of the bonds each year for 10 years.
To do so, company ABC must deposit $1 million each year into a sinking fund, which is separate from its operating funds and is used exclusively to retire this debt.
This strategy ensures that company ABC will pay off the $10 million in 10 years
Establishing a Sinking Fund
When creating a sinking fund, the issuer sets up a custodial account and makes systematic payments into it. Payments might not begin until several years have passed. Amounts are typically fixed, although variable amounts may be allowed based on earnings levels or other criteria set by the fund's provisions. Unless preferred stock is used with sinking funds, failure to make scheduled principal and interest payments results in defaulting on the loan.
Advantages and Disadvantages of a Sinking Fund
A sinking fund improves a corporation's creditworthiness, letting the business pay investors a lower interest rate. Because of the interest savings, the corporation has more net income and cash flow for funding operations. Also, businesses may deduct interest payments given to lenders from their taxes, helping increase cash flow as well. Corporations may use the savings for covering sinking fund payments or other obligations. In addition, investors appreciate the added protection a sinking fund provides, making investors more likely to lend a company money. A business that is controlling its money is less likely to default on outstanding debt.
However, if interest rates decrease and bond prices increase, bonds may be called and investors may lose some of their interest payments, resulting in less long-term income. Also, investors may have to put their funds elsewhere at a lower interest rate, also missing out on potential long-term income.
