Will you invest in a bond with no or low default risk? Is it possible that a bond will have no credit risk? Well, it does through a fund. It is called the sinking fund and it enables a company to buy back the bonds before maturity. It is a pool of money set aside by a company to repay a debt or bond issue. This article covers the sinking fund and its features in detail.
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What is Sinking Fund?
A sinking fund is a fund set up for a specific purpose, for example, to pay off debt or a loan. Usually, companies that issue bonds set up this fund to buy back bonds. They set aside a small amount regularly as the maturity date of the bond arrives. Also, through this fund, the company pays off a part of the debt, thus reducing the final payment. By setting up this fund, companies entice investors as it convinces them that the company will not default on the payment. Hence, they are created to make debt payments easier and also ensure that there are no defaults.
Features of Sinking Fund
The following are the features:
Low Default Risk
A sinking fund acts as a protection against default risk. The company sets aside money regularly when the bond is created or a loan is taken, and this ensures the investors or creditors that the chances of default are low. Also, when the fund is created, the companies pay off part of the debt every year, and hence the sum owed at maturity will be lower.
This fund lowers the credit risk and increases the creditworthiness and credit ratings of a bond. This, in turn, reduces the interest the companies have to pay to the creditors or investors. Moreover, a company with a high credit rating can easily raise funds by issuing bonds or debt.
A company’s financial situation is never certain. Even when the company is not doing financially well, the sinking fund will ensure the company’s ability to buy back bonds or pay off debt is not hampered. It enables a company to retain stable finances.
Types of Sinking Fund
The following are the types:
- Callable Bond Sinking Fund: A fund for calling the bonds issued by the company at a fixed price.
- Specific Purpose Sinking Fund: A fund created for a specific purpose, such as to buy a particular asset.
- Regular Payment Sinking Fund: A fund to make regular payments to bondholders or trustees.
- Purchase Back Sinking Fund: A fund to purchase back the bond. The repurchase can be either at market price or sinking fund price.
Uses of Sinking Fund
The following are the uses:
- This fund is a financial tool utilized by governments to set aside a fixed amount of money on a regular basis for the purpose of paying off outstanding debts.
- It is not limited to just managing risky debt, but can also be used for other purposes.
- When a company has profits that cannot be distributed due to upcoming projects, directing a portion towards a sinking fund may be a more beneficial option than distributing all the money to shareholders.
- These funds can effectively increase investment potential and provide more flexibility when liquidating investments. They also serve as a valuable tool for managing construction projects.
How Does a Sinking Fund Work?
It is a fund set up by companies for a specific purpose. When this fund is set up, the company periodically transfers money into it. The main purpose of this fund is to lessen the risk of being short on cash when the debt or bond matures. Through these funds, the company pays a portion of debt each year. This reduces the final payout when the bond or debt matures.
When a company has a sinking fund for a bond, it makes the bond more attractive as well as less attractive too. Through this fund, investors are ensured that the credit risk is lower. However, there is a repurchase risk associated with it. When a bond is repurchased using funds in the sinking fund, the purchase happens at a sinking fund price, which is much lower than the market price. Hence, investors will have repurchase risk, if not default risk.
Key Takeaways on Sinking Fund
A sinking fund might seem quite easy to start and understand. But most companies fail to create one due to lack of discipline to set aside the amount regularly. It is an account that holds money set aside to pay off a bond or debt.
It helps in paying off the debt on maturity or in buying back the bonds in the open market. Also, paying off debt early with this fund saves the company from the interest expense.
Having this fund will boost investor confidence. In other words, a company with high debt is a risky investment option. However, once investors know that the company has a sinking fund, a certain level of protection is ensured. In case of bankruptcy or default, at least the investments are guaranteed.
Also, companies with poor credit ratings find it difficult to get investors unless the interest rates are high. But, having this fund will guarantee some protection and can attract investors. Bonds issued with these funds may be low-risk investments as they are backed by a collateral fund. However, these bonds also carry lower yields.
Frequently Asked Questions
Contribution = Money to Accumulate * [Interest/ Interest + 1)^((Compound Frequency * Period)-1)]
Money to accumulate is the lump sum amount you need on maturity
Interest is the annual compound interest rate
Compound Frequency is the number of times the interest is paid.
The period is the number of years for which contributions are made
Savings are funds for non-work financial requirements. While a sinking fund is for paying bond liability in advance of upon maturity.