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A bond sinking fund may allow a company to buy back bonds at certain prices and intervals. If so, this can have a countervailing impact on the effective interest rate that investors are willing to pay, since there is some uncertainly about whether their bonds will be retired early, and at what price. Similar in concept to a sinking fund for a corporation that issues and repays bonds, a sinking fund for household finances involves setting aside a certain amount of money each month to help pay off debts or to finance large purchases in the future. The idea is that by consistently saving relatively small amounts of money, there will eventually be enough stored up to spend toward something more significant. These monies are then invested by the trustee and eventually are used to pay the interest and principal of the bond. The company could have opted not to establish a sinking fund, but it would have had to pay out $20 billion from profit, cash, or retained earnings in year five to pay off the debt.
Since the money in the sinking fund is reserved strictly for the repayment of bonds, it cannot be used to pay for short-term liabilities. A bond sinking fund, apart from being a reserve of cash or assets for debt repayment purposes, is also a form of pre-funding which isn’t taxed by the Internal Revenue Service (IRS). The term “pre-funding” means that income taxes are not applicable to the principal repayments. A bond sinking fund is a fund set aside by the issuer in order to retire bonds when they mature. When investors purchase a bond, they generally look forward to receiving their interest payments in addition to the repayment of the face value of the security on its maturity date.
- This mechanism may sound very similar to a callable bond, but there are a few important differences investors should be aware of.
- However if no reservation has been made to retire the bond at maturity (which is also known as “pre-funding”), and if the issuer defaults on its obligation to make timely repayment, then it can result in a default.
- If economic conditions had deteriorated or the price of oil collapsed, Exxon might have had a cash shortfall due to lower revenues and not being able to meet its debt payment.
- Setting aside money to pay off debts is a prudent financial decision for companies to manage their obligations when debt comes due.
Since only $8 billion of the $20 billion in original debt remains, it would likely be able to borrow more capital since the company has had such a solid track record of paying off its debt early. Lower debt-servicing costs due to lower interest rates can improve cash flow and profitability over the years. If the company is performing well, investors are more likely to invest in their bonds leading to increased demand and the likelihood the company could raise additional capital if needed. To ensure the repayment of the principal, some bond agreements require that the issuing corporation create and maintain a sinking fund.
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Setting aside money to pay off debts is a prudent financial decision for companies to manage their obligations when debt comes due. Companies that don’t, may struggle to find the capital to make good on their outstanding debt obligations. Typically, corporate bond agreements (also called indentures) require a company to make periodic interest payments to bondholders throughout the life of the bond, and then repay the principal amount of the bond at the end of the bond’s lifespan. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
As an investor, you need to understand the implications a sinking fund can have on your bond returns. Sinking fund provisions usually allow the company to repurchase its bonds periodically and at a specified sinking fund price (usually the bonds’ par value) or the prevailing current market price. When an investor purchases a bond, they expect to receive interest payments and also get back their principal when the bond matures. However if no reservation has been made to retire the bond at maturity (which is also known as “pre-funding”), and if the issuer defaults on its obligation to make timely repayment, then it can result in a default. A sinking fund refers to the collection of cash or other assets set apart from the firm’s other assets which are used only for a specified purpose.
A callable is typically called at an amount slightly above par value and those called earlier have a higher call value. For example, a bond callable at a price of 102 pays the investor $1,020 for each $1,000 in face value, yet stipulations might state that the price goes down to 101 after a year. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise. This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. The sinking fund is a type of fund that is generally placed under the control of a trustee or agent who is independent of the entity that established the fund.
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The prospectus of the bond issue can provide details of the callable feature including the timing in which the bonds can be called, specific price levels, as well as the number of bonds that are callable. Typically, only a portion of the bonds issued are callable, and the callable bonds are chosen at random using their serial numbers. In other words, the amount owed at maturity is substantially less if a sinking fund is established.
However, if no reservation has been made to retire the bond at maturity, such as a sinking fund (or “pre-funding”), then the issuer can default on its obligation to make timely repayment. Also, if interest rates decrease, 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 that redeems the bonds from investors at face value. The investors would lose some of their interest payments, resulting in less long-term income. A sinking fund is typically listed as a noncurrent asset—or long-term asset—on a company’s balance sheet and is often included in the listing for long-term investments or other investments.
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Where Does a Sinking Fund Arrangement Show Up on a Company’s Balance Sheet?
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Other Types of Sinking Funds
Other important features of bonds include the yield, market price, and putability of a bond. A bond sinking fund is an escrow account into which a company places cash that it will eventually use to retire a bond liability that it had previously issued. The escrow account is administered by an independent trustee, which is also responsible for investing the funds within a specific set of predetermined investment criteria, as well as for redeeming bonds under the terms of the bond agreement. The options are to repurchase them periodically on the open market, or at a specific call price, or at the lower of the market price or a specific call price, or to only repurchase at the maturity date of the bonds.
Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year. The number of periodic payments to the fund is based on guide to lenders review the expected return that the trustee can earn on the assets in the fund. Paying the debt early via a sinking fund saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen.