While most people have likely never heard of a sinking fund, it is a commonly used financial instrument. Simply put, a sinking fund is a fund containing money that has been set aside or saved to pay off a debt or bond.
Companies that issue or take on debt need to pay off that debt in the future, and a sinking fund ensures that the money is available to pay the debt without having to suddenly outlay a large chunk of revenue. With a sinking fund, organizations contribute to the fund each year leading up to the debt or bond maturing and coming due.
How Sinking Funds Work
A sinking fund is basically a saving account that helps companies with debt — usually in the form of a bond. They gradually add money to the sinking fund, in order to avoid a big lump-sum payment all at once. Some bonds legally require a sinking fund to ensure that money is available to repay the debt.
These types of bonds typically allow organizations to redeem a bond early, using the sinking fund. While the sinking fund ensures companies have enough funds set aside to pay off their debt, they can also use the funds to repurchase preferred shares or other bonds, if they wish.
Bond Repayments
Corporate bond agreements (also called indentures) typically require a company to make periodic interest payments to bondholders throughout the lifespan of the bond. Then, they repay the principal amount of the bond when it matures (or comes due at a certain date).
If a company issues a bond with a $10,000 face value and a 10-year lifespan, it would likely pay interest payments to their owners every year. In the bond issue’s final year, the company would need to pay the entire $10,000 principal amount.
While the company might have been able to afford relatively small $100 interest payments, repaying the $10,000 all at once might cause some cash flow issues. This is especially true if the company is in poor financial shape when the bond comes due. It’s difficult to predict how fortunes might change over time, especially when it comes to something like a ten-year bond.
Sinking Fund Example
Let’s say Microsoft issued $20 billion in long-term debt in the form of bonds. Interest payments were to be paid every six months to bondholders. The company establishes a sinking fund, whereby $4 billion must be paid to the fund each year to be used to pay down the debt. By year three, Microsoft would have paid off $12 billion of the $20 billion in long-term debt.
The company could have opted not to establish a sinking fund. However, they would then have to pay out $20 billion from profits, cash, or retained earnings all at once when the five-year bond term is up. They would have also had to pay five years worth of interest payments on the entirety of the debt.
Protection Against The Unexpected
Let’s stick with our Microsoft example. If the economy had turned sour or there had been a market crash, Microsoft might have had a serious cash shortfall. They could have struggled to meet the $20 billion debt obligation they agreed to.
Paying the debt early via a sinking fund saves a company interest expenses. It also prevents additional financial difficulties, should economic or financial conditions worsen. The sinking fund might also allow Microsoft the option to borrow more money, if needed.
Benefits of Sinking Funds
The main benefit of a sinking fund is that it lowers debt default rates. By ensuring the money is available to pay off a bond, the risk that an organization will not be able to pay off the debt is dramatically lowered.
A sinking fund adds an element of safety to a corporate bond. The fund also helps investors have some protection in the event that a company or organization files for bankruptcy. A sinking fund also helps a company remove concerns of default risk. That can, as a result, attract more investors for their bond in the first place.
Additional Benefits
Another benefit of a sinking fund is that it can improve a company’s creditworthiness. That will help the entity secure lower interest rates on the debt or other bonds they take out. Organizations that use sinking funds tend to have more positive credit ratings for their debt.
Good credit ratings lead to preferred or lower interest rates. That’s helpful, as it saves money and lowers the total cost of taking on new debt. Lower debt-servicing costs due to lower interest rates can improve cash flow and profitability for a company over many years.
Callable Bonds
If the bonds are callable, it means the company can retire or pay off a portion of the bonds early. They will use the sinking fund to do this, when it makes financial sense for them to do so. The bonds are embedded with a “call option” that gives the issuer the right to “call in” or “buy back” the bonds.
The prospectus of the bond issue provides details of the callable feature. Those details include the timing in which the bonds can be called, specific price levels, as well as the number of bonds that are callable.
Interest Rate Decline
If interest rates decline after a bond is issued, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly issued debt, at a lower interest rate.
If interest rates fall, which would result in higher bond prices, the face value of the bonds would be lower than current market prices. In this case, the bonds could be called by the company who redeems the bonds from investors at face value. The investors would lose some of their interest payments, resulting in less long-term income.
Sinking Funds For Personal Use
Sinking funds are typically only used in the business world. However, you can apply their concept to your own finances too. For example, let’s say you borrow $2,500 from a friend or relative, with the promise to pay it all back in six months. If you have any doubts (even minor ones) that you’ll struggle to come up with the lump sum at the six month mark, you should start a sinking fund.
You’d need to add $416 to the fund every month in order to have the full amount at the end of your promised term. Of course, even contributing less per month to this personal sinking fund helps. If your sinking fund is only worth $1,000 after six months, you only need to come up with an additional $1,500 to make good on your debt.
Exceptions
The reason most people don’t incorporate sinking funds into their personal finances is that almost every consumer debt product requires a rigid payment plan. Think about it. Your mortgage payments and car loans are set up to be paid automatically on a weekly or monthly basis. If you take out a personal loan, it’s the same thing. Even your credit card or line of credit debt has a monthly minimum payment. You can’t just call the bank and tell them “hey, I’m saving the money in a sinking fund, I’ll send it all over in 24 months.”
The concept of a sinking fund is worth considering though. It’s basically slowly pooling money over time, in order to cover a big expense (in this case, a debt). If you start a sinking fund for something that isn’t a debt, that’s basically just called “saving up” for some future planned expense.
The Bottom Line
Most consumers are not likely to use a sinking fund. Frankly, you may not even be aware of them in your daily life. However, they are an important financial tool for companies to use when taking on debt or issuing bonds.
By ensuring that organizations have the money set aside to repay their debt obligations and lowering the risk of default, sinking funds help ensure the financial system continues to operate successfully and as intended. In many respects they are an invisible but crucial component of finance.
