What Are Sinking Fund Bonds?

The sinking fund bonds are defined as the bonds wherein the bond issuer specifically keeps a set defined amount to repay the holders of the bonds on the date of maturity or predefined dates. It is a bond made by the issuer to be catered as collateral in case the issuer defaults on its payments to the holders of the bonds at a defined future date. 

A company prepares an initial cash corpus, which is then handover to the independent trustee. The independent trustee would then use the amount received from the company to invest it further in assets having long-term maturity. Such investment may be broken only to retire existing issues of bonds.

• Sinking fund bonds are bonds in which the issuer expressly reserves a specific amount to repay bondholders on maturity or preset dates.
• If the issuer fails to make payments to bondholders on a predetermined future date, the bond issued by the issuer acts as collateral. A company, for example, establishes an initial cash corpus, which is eventually transferred to an independent trustee.
• Sinking fund bonds come in three varieties: sinking fund bonds for callable bonds, sinking fund bonds for aligned purposes and aims, and sinking fund bonds for bond repurchase.

The sinking fund bonds are the ones that are debt instruments where investors invest their money to get regular income in the form of interest rates but the issuer creates a sinking fund for the purpose of repayment. This sinking fund is a pool of money that is utilized for the repurchasing the bonds from investors or payment of interest.

This is a great arrangement because it puts less pressure on the issuer regarding repayment because funds are arranged in a planned way. The company remains financially stable and more liquidity is available for usage in other areas of business which require more financial support.

These kinds of bond become more reliable and less risky from the point of view of investors because they are backed by the sinking fund which provides a cushion to investors in case the issuer is not able to arrange funds for debt repayment, a situation that arise commonly during bankruptcy or liquidation or any kind of unforeseen contingency.

Therefore, it is beneficial for both the investor and the issuer. The issuer has a provision ready to manage the long-term debt which also brings down the cost of interest payment. The bondholders also feel safe due to less chance of default risk and an assurance of regular payment or steady income from the investment.

Let us study the different types of such funds available in the market for investment.

 #1 - Sinking Fund Bonds for Callable Bonds

Whenever there is a decrease in rates of interest, the company callbacks its bonds by buying them back from the holders at a premium. A sinking fund bond may help the company buy the bonds issued by providing the needful cash cushion for the company.

#2 - Sinking Fund Bonds for Aligned Purpose and Goals

The business may have incorporated certain goals and purposes for which it may require cash to service them in the future. The business may incorporate such a bond to service such goals in the upcoming future.

#3 - Sinking Fund Bonds for Buyback of Bonds

The business may look to retire its debt early. To cater to this goal, it may incorporate such a fund to cater to the buybacks of existing issued bonds from the holder of bonds.

It can be determined using the time value of money relationship as described below:

Here,

• The amount contributed regularly is represented by A.
• The rate of interest is represented by r.
• The time period is represented by n.

We can understand the concept with the help of some suitable examples as given below:

Example #1

The company holds a debt of $1 million at the rate of interest of 6% and with a repayment period of 5 years. The company plans to incorporate a sinking fund of $60,000 at the end of 5 years, with the rate of interest as 4%. The company must determine the periodic annual payments to formulate the sinking fund.

The Periodic amount would be determined as follows:

• $60,000 = A * (1+0.04)^5 -1 /0.04
• $60,000 = A * (1+0.4)^5 -1 /0.04
• $60,000 = A * (1.2167 -1) /0.04
• $60,000 = A * (0.2167) /0.04
• $60,000 = A * 5.4163
• A = $60,000 / 5.4163 = $11,077.6

Therefore, the company must save $11,077.6 into the sinking account, which could then be utilized in the early or easy payment of the bonds.

Example #2

Suppose the company has issued callable bonds of $20 million at the rate of interest of 8 percent for ten years.  There has been a decrease in interest rate by 2 percent, and the updated rate of interest is at 6 percent. The company additionally maintains a sinking fund bond of $5 million.

The company may call the bonds back only to reissue them at a lower rate of interest. The company may utilize the sinking fund bonds to repay the call premium associated with the callable bonds.

Example #3

Suppose the business has a debt worth $10 million to be paid off at the rate of a 6% rate interest after ten years. The company additionally faces a risk of default as well as interest rate risk. To cater to such a situation and to handle their exposure, the company plans to incorporate a sinking fund bond wherein it plans to contribute $2 million annually for three years.

After the end of three years, the business would have $6 million to pay off the remaining debt payable after the end of three years.

Every financial concept have their own advantages and disadvantages. Let us study the advantages of this concept in detail.

• The sinking fund bonds, if used strategically, can be used to pay off debt and liabilities early.
• It also facilitates timely payments of debt obligations on the date of maturity.
• If the rates of interest decrease, then these bonds can be utilized to call back existing debt issues. It can be used to buy back existing bond issues from the holders of the bonds.
• Since there are early payments of debts, it enhances the goodwill of the issuing business.

• From the perspective of investors, the holder of the bonds loses on the interest payments since their bonds were paid off early using sinking bond funds.
• The business may not retain its existing investor confidence since the issues were called back using sinking bond funds.
• Since, from the point of view of investor, this bond has lower risk, the expected return on it will also be low. The yield will be lower compared to bonds that do not have the sinking fund.
• Since the sinking fund is used to retire the bonds at a predetermined price, the potential for capital appreciation will be missed. In case the market rates fall, then the old bonds that have high interest rate, will start trading at a premium price.
• Thus, we see that this type of bonds have both advantages and disadvantages which are to be analysed before investing in them.

• The business employs sinking bond funds with a very low credit rating and bad credit profile.
• It is very risky for the investor to invest in such bonds as such bonds have high default risk.
• It may be used to buy back any pre-existing bonds in the open market.
• They are normally classified as a restricted assets for the issuing business.
• In the balance sheet, sinking bond funds are recorded under the non-current asset section with the account label Investments.
• Although these bonds are composed only of cash, they are never part of current assets as they have primarily been prepared to pay off long-term debt and not current liabilities.

Sinking Fund bonds are made when the issuing company has to safeguard itself from interest rate risk and default risk. The sinking fund bonds are formed by the business which is not cash-rich. Rather, they are cash deficient and have strained financial health. They are normally visualized as collateral for the holder of the debt, which would be used by them when the company defaults.

The business may incorporate this bond under the supervision of a trustee. The trustee is an independent member that supervises the administration of such bonds. The trustee is required in such situations due to the larger size of sinking funds, and these funds have to be managed in the system so that they can be used to redeem the debt early.

This has been a guide to what are Sinking Fund Bonds. We explain the types, formula, examples, advantages & disadvantages of the concept. You can learn more about fixed income from the following articles –

• Gold Fund Definition
• Calculate the Sinking Fund
• Negative Yield Bond Types
• Amortization of Bond Premium