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.

It is an account set-up by a municipality to redeem or purchase its bonds prior to

maturity. By having a sinking fund, a municipality can reduce its debt load over
time, avoiding the need to finance a large lump sum when the bond reaches
maturity.  Typically, a municipality is required to put a certain amount in the
sinking fund every year.

How it works:

To understand how a sinking fund works, let's assume Company XYZ issues $10
million of bonds that mature in 10 years. If the bonds have a sinking fund,
Company XYZ might be required to retire, say, $1 million of the bonds each year
for 10 years. To do so, Company XYZ 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 XYZ will pay off the $10
million in 10 years.

Establishing a sinking fund is usually a matter of setting up a custodial account into which the
sinking fund payments will go. The issuer then makes payments to the trustee of the custodial
account. The sinking fund payments are usually fixed amounts.This is called randomly calling
for redemption( at per value).

some bond indentures allow for variable sinking fund provisions (usually based on earnings
levels or other conditions). Sometimes the issuer does not have to begin setting aside sinking
funds for several years. Regardless of the ultimate size and timing of the payments, failure to
make the payments is usually deemed an act of default in bond indentures .

Types
Quota-Based Sinking Funds

Some companies setup sinking funds with the goal of purchasing a specific amount
of bonds back over each calendar year. The company will attempt to buy the same
amount of bonds every year.

Callable Bonds

Some companies are able to repurchase bonds at a special price. These bonds,
known as callable bonds, allow the issuer to retain the right to redeem the bond
before maturity.r as long as they are able to find money to do so.

Purchase Price Based Sinking Funds

The third type of sinking fund pertains to how a bond is bought back. The issuer
can either decide to repurchase the bond at market value, or buy the bond at the
sinking fund price. Sinking fund prices are determined in bond indentures and are
generally lower than both call and market prices.

Balance Accumulation

The final type of sinking fund is when a company makes regular cash payments
directly to a trustee to be held in a special account. The goal of this account is for
the accumulated assets to match the price of outstanding bond payments. Capitol
within the account is sometimes used to purchase stocks and securities in pursuit of
raising the account balance.

Advantages:

Risk Reduction

Corporations sometimes go bankrupt. When this occurs, bondholders and the

government get priority access to the proceeds of liquidation. However, not all
bonds get equal access.
Lower Interest Payments

A corporation can use a sinking fund to retire a bond issue a portion at a time. For
example, a sinking fund for a 10-year bond may buy back 10 percent of the bonds
each year, thereby reducing interest payments by a like percentage. The remaining
bondholders appreciate the lower interest payment obligation, since it reduces
default risk. Stockholders also like it, because expenses reduce net income and thus
hurt stock prices.

Higher Bond Prices

Demand for bonds can change if prevailing interest rates move up or down; this
effect may overwhelm the consequences of reduced supply on the bond’s price

Disadvantages

Sinking funds carry a couple of disadvantages.

Money set aside in a sinking fund is not available to grow the company or pay
dividends -- a disadvantage to stockholders.

Additionally, early redemption is facilitated by a sinking fund, which reduces the

number of interest payments a bondholder receives.

If interest rates are lower when the bonds are redeemed, the bond investor may not
be able to obtain a source for the same interest income as that paid by the
redeemed bond.