Sinking Fund Explained for Dummies

What is a sinking fund?

A sinking fund is a type of fund that is used by a business to pay off a bond or debt. Sinking funds can also be formed to serve other purposes such as future capital expenditures, the replacement of a wasting asset, or buying back preference shares (preferred stock). Although, a sinking fund’s main purpose is to provide funds to pay back bonds or portions of bonds issued by a company.  

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Features of a sinking fund

• Specific purpose

A sinking fund has a specific purpose and is to be executed at a particular time, such as the repayment of a loan or a bond issued.

• Proactive

It is proactive because it prepares the owner of the fund for the payment of a future expense.

• Gradual accumulation

The owner of the fund regularly deposits a certain amount of money, preventing a once-off lump sum payment when the pay off date of the debt or bond arrives.

• Reduces default risk

A sinking fund provides an element of safety for investors who own corporate bonds. Since funds are reserved to pay off bonds at maturity, the risk that a company will default on the amount owed at maturity is reduced.   Express differently, a sinking fund lowers default risk because the sum owed at maturity of a bond is significantly less. A sinking fund also protects investors in the event of a company’s bankruptcy.  

Bonds with an attached sinking fund feature

Some corporate bonds are issued by companies with a sinking fund feature attached to them. A sinking fund enables a company to repay a certain portion of its bonds each year with the funds available in the sinking fund. Sinking fund provisions allow a company to buy back its bonds from time to time at a specified sinking fund price, which is usually the par value of the bond or the prevailing current market price. Because of this, companies usually use the funds in their sinking funds to buy back their bonds when interest rates have decreased, implying that the market price of their existing bonds has increased. Due to the occurrence described above, companies can repurchase their bonds at the specified sinking fund price, which is less than the market price. Investors need to understand the implications on their bond returns when companies use sinking funds to repurchase their bonds because this strategy can cause them to lose money. Although a strategy sounds very similar to callable bonds, there is a key difference between callable corporate bonds and corporate bonds with an attached sinking fund feature, namely: a company is restricted to a certain limit to repurchase an issued bond at the sinking fund price, whereas call provisions generally allow a company to buy back the full amount of the bond issued.  

Advantages of sinking funds

• Entice investors

Investors are well informed about potential risks involved when investing in bonds issued by companies with substantial amounts of debt. However, once convinced that a company has an established sinking fund, they are more prepared to buy bonds issued by the company because the sinking fund provides a certain level of protection in the case of a default or bankruptcy.

• Possibility of lower interest rates

Typically, poor credit ratings make it difficult for a company to attract investors who are interested in their bonds unless the investors are offered higher interest rates. The alternative protection offered by a company’s sinking fund to investors enables a company to offer lower interest rates and still attract investors.

• Good credit standing

Certain financial issues (sometimes unforeseen) can threaten a company’s economic situation and financial wellness. However, a company’s ability to repay its debts will not be jeopardised when it has a sinking fund or funds to repay debts and repurchase its bonds.   This effectuates a good credit standing and satisfied and confident investors.  

What are the differences between a sinking fund, a reserve account, an emergency fund, and a savings account?

Although the four funds and accounts may sound similar and be used interchangeably, there are fundamental differences that an investor or business owner should be aware of.  

• A sinking fund is created for a specific purpose, such as repurchasing a corporate bond or paying off debt.

• A reserve account, such as retained earnings, refers to profits that have been reserved for a variety of purposes, such as expanding operations, acquiring fixed assets, or paying unforeseen expenses.

• An emergency fund’s purpose is to have money available in the event of a crisis. It is a fund set aside for unknown events that can occur anytime. For example, the replacement of a vehicle after an accident, or a major mechanical failure in one of the production machines.

• A savings account is also a type of fund that is set aside to be used in the future. However, contrarily to a sinking fund that has a particular purpose, a savings account is established for any purpose that it may serve.

 

Reporting a sinking fund in accounting

A sinking fund is considered a non-current asset, also known as a long-term asset, and as such reported on the balance sheet of a company in the long-term asset section, immediately after the current assets section. It is often included under the heading ‘investments’ in the long-term asset section. The reason a sinking fund is regarded as a long-term asset and not as a current asset, even though the fund contains only cash, is that it cannot be used to pay current liabilities or to acquire current assets. For example:

• The money in a sinking fund is used to pay off bonds, which are long-term-liabilities,

or,

• the sinking fund is used for capital expenditures, which are categorised as long-term assets.

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