When you issue bonds, you can repay the money you borrow by making periodic payments to a trustee, a process known as a sinking fund. All of the bonds in the issuance are eventually called due to maturity after the trustee retires a portion of the issue by purchasing them on the open market. The provision known as the sinking fund is, in essence, just a pool of money that a firm puts away in order to aid in the repayment of earlier issues and to maintain the company more financially stable as it sells bonds to investors.
Companies that issue bonds will often set aside funds, known as a sinking fund, to eventually use to retire the bonds they have issued.
Bonds that are issued utilising sinking funds are deemed to have a smaller risk because the collateral that is held in the fund is utilised to back the bonds. As a result, the yields on these bonds are lower.
Callable bonds can be redeemed with money from sinking funds.
Methods of Bond Interest Repayment
Corporate bond arrangements typically need the issuing business to reimbursement the bond’s principal plus interest at the end of the bond’s term, and in certain situations, interest only. Bondholders’ financial interests are intended to be safeguarded by these duties.
Let’s pretend for the purpose of argument that Cory’s Tequila Company (CTC) is issuing $1,000 bonds with a 10-year maturity. Interest payments (sometimes referred to as coupon payments) are scheduled to be made annually to bondholders. In the last year of the bond issue, in addition to the final coupon sinking fund payment, CTC would have to repay the entire $1,000 principle amount of each bond that was still outstanding.
The benefits of a sinking fund should be obvious.
Each year, a portion of the company’s outstanding bonds is repurchased using funds from a sinking fund. In order to reduce the likelihood of financial difficulties in the next decade, the corporation may choose to create such a fund. Because the firm will have paid off a percentage of its debt each year using the sinking fund, the total amount that will need to be paid at the conclusion of the 10-year term will be much smaller.
As a bond investor, you should be well-versed in the ways in which a sinking fund might alter your yields. Periodically, the company can repurchase its bonds at either the sinking fund price (usually equal to the par value of the bonds) or the market price, thanks to sinking fund provisions. Thus, as interest rates fall, companies often repurchase bonds using funds from their sinking funds (which indicates that the market prices of their existing bonds have increased). This is because the issuers have the option to repurchase the bonds from investors at a price below market value, the sinking fund price.
What, exactly, is a “Sinking Fund” when it comes to individual financial planning?
Putting money aside on a regular basis can be thought of as “sinking” money, and it can be used to help pay off debts or finance significant expenditures down the line. In many ways, the idea is comparable to, and functions like, a sinking fund for a company that issues and repays bonds. You may save up for something much more meaningful to you if you put a little bit of money aside on a regular basis.