What is a Sinking Fund?
A sinking fund is a type of fund that is created and set up purposely for repaying debt. The owner of the account sets aside a certain amount of money regularly and uses it only for a specific purpose. Often, it is used by corporations for bonds and deposits money to buy back issued bonds or parts of bonds before the maturity date arrives. It is also one way of enticing investors because the fund helps convince them that the issuer will not default on their payments.
Basically, the sinking fund is created to make paying off a debt easier and to ensure that a default won’t happen because there is a sufficient amount of money available to repay the debt. Though most bonds take several years to mature, it is always be easier and more convenient to be able to reduce the principal amount long before it matures, consequently lowering credit risk.
The reasoning for sinking funds
A lot of people are aware of what a sinking fund is because even school children understand that it is an important and effective way of saving money for something that they want to buy or own. In school, a class that wants to culminate the school year with a field trip to the zoo can create a sinking fund which, toward the end of the year, will have grown to the desired amount and may be used to cover their field trip expenses.
In such a way, the students do not have to take out extra money from their pockets because, throughout the year, they were already busy depositing money into their sinking fund. In short, a sinking fund is proactive because it prepares the individual for an imminent expense to be paid.
Advantages of sinking funds
The following are the advantages of sinking funds:
1. Brings in investors
Investors are very well aware that companies or organizations with a large number of debts are potentially risky. However, once they know that there is an established sinking fund, they will see a certain level of protection for them so that in the case of a default or bankruptcy, they will still be able to get their investment back.
2. The possibility of lower interest rates
A company with poor credit ratings will find it difficult to attract investors unless they offer higher interest rates. A sinking fund offers alternative protection for investors so that companies can offer lower interest rates.
3. Stable finances
A company’s economic situation is not always definite, and certain financial issues can shake its stable ground. However, with a sinking fund, the ability of a company to repay its debts and buy back bonds will not be compromised. This results in good credit standing and confident investors.
Examples of a sinking fund
To illustrate the concept more clearly, let us consider a franchisee of 7-Eleven who issues $50,000 worth of bonds with a sinking fund provision and establishes a sinking fund wherein the franchisee regularly deposits $500, with the intent of using it to buy back bonds slowly before they mature.
The provision will then allow him to buy back the bonds at a lower price if the market price is lower or at face value if the market price goes higher. Eventually, the principal amount owed will be lower, depending on how much was bought back. However, it is important to remember that there is a certain limit to how many bonds can be bought back before the maturity date.
Another example may be with a company issuing $1 million of bonds that are to mature in 10 years. Given this, it creates a sinking fund and deposits $100,000 yearly to make sure that the bonds are all bought back by their maturity date.
Sinking fund vs. Savings account
Basically, there is only a very small difference between a sinking fund and a savings account as both involve setting aside an amount of money for the future. The main difference is that the sinking fund is set up for a particular purpose and to be used at a particular time, while the savings account is set up for any purpose that it may serve.
Sinking fund vs. Emergency fund
A sinking fund is not similar to an emergency fund as the former is purposely established for something definite while the latter is for something unexpected. A person with a sinking fund already knows where the money will go and when it will go. Say, for example, a mortgage on a house.
On the other hand, the emergency fund is set aside for an event that is not known but can happen anytime. For example, one keeps a certain amount as an emergency fund that can be spent on a car accident, which is something that can never be predicted.
A sinking fund is very easy to start and understand. However, many people fail to create one because they lack the discipline to set aside a specific amount regularly.
Thank you for reading CFI’s explanation of a sinking fund. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: