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What is a Sinking Fund?

Origins of the “Sinking Fund”

A Sinking Fund is a strategy that has not gained much importance even in the present scenario of global downfalls of many economies. It is a distinct fund[i] which a company sets aside to pay off the bonds at maturity. The name sinking fund is the English version of Fondo d’ammortamento, a term used in the Indian Peninsula since the 15th century. By the 18th century, this term was used by Great Britain for funds generated for paying national debts.

By the middle of the 19th century, the United States started using this term specifically to fund pools to retire corporate and public debts from bond issues. So, the primary use of the sinking fund is that the amount owed to bondholders at maturity is reduced considerably less, and thus the investors can be ensured some protection if the company goes bankrupt. This provision of a sinking fund makes the bond more attractive, and therefore the firms can reduce the interest rates of the obligation. As a result, the credibility of the company is increased significantly, which leads to positive credit ratings for its debt.

Advantages of Sinking Funds 

  • Brings in Investors

Nowadays, people are aware that investing in companies which have a large number of debts is very risky. However, if there is a proper functioning sinking fund, they may find a certain level of security that their money is in safe hands.

  • Low-Interest Payments

A company can use the sinking fund to retire a bond issue one portion at a time. For example, a sinking fund for a ten-year bond may repurchase 10 percent of the relationships each year, thereby reducing the interest payments[ii]by a good percentage. The investors appreciate this lower interest commitment as it reduces potential risk.

  • Higher Bond Prices

When the credit risk of the bond gets reduced, the market interest rates may get reduced, thereby increasing the bond prices favorably. Thus, the company takes charge, and the call feature of the sinking fund provision helps out. The callable function allows the companies to buy back the bonds at face value.

  • Buying New Equipment Without Bank’s Assistance

A company may also create a sinking fund for future ventures or expenses like purchasing new machinery. Thus, keeping a part of the company’s profit into a separate account can enable them to focus on these issues without any hassle.

How Do Sinking Funds Work?

Anybody might think that a sinking fund seems like a savings account and nothing else, but what they might not know that it has an absolute power attached to it. Suppose a firm ABC has issued 100 bond certificates at $1000 per 5 bonds at 5% interest payments every year for the next ten years.

  • They will not be worried about the interest payments because it will be $5,000 per year. Instead, they will worry about the principal amount.
  • So, the company ABC decides to create a sinking fund provision of $5,000 every year, and it also decides to buy back the bonds every year at face value.
  • Therefore, at the time of maturity, the firm would be able to buy back $50,000 worth of bond certificates, and the principal amount would be $100,000-$50,000= $50,000

Sinking Fund Example in Current Scenario 

Arunachal Pradesh Government (India) had created a consolidated sinking fund in the year 1999-2000 to make advance strategies to cope with unforeseen emergencies. The government has invested a total sum of Rs. 169.90 crore so far[iii]. The Reserve Bank of India (RBI) handles this fund. The RBI has invested the sinking fund in the Government of India securities and earns a reasonable interest. The total accumulated fund in the sinking fund would be more than Rs 220 crores, including the interest accrued.

Things to keep in mind while buying bonds

  • Before buying bonds, look at all the aspects of the relationship and whether a sinking fund is attached to it or not.
  • As this fund gives an upper hand to the firms, it is always better to read the terms and conditions before purchasing the bond certificates.

Where to Store the Records and Transactions

As an individual, people may build sinking funds such as gift funds, vacation funds, etc. or deposit the money in their ordinary savings accounts. Business firms also build cash pools in a Cash Box to accumulate funds for a seasonal get-together or a similar purpose. However, the significant sinking funds that firms create for making investments, repaying debts, etc. must appear in the company’s accounts, and they can earn interest on the fund deposits during the fund life. The sinking fund itself exists as a balance sheet asset account[iv]and appears under long term investments.

Conclusion 

A sinking fund is elementary to start and understand. It requires a particular discipline for keeping money out in another box. But once followed and maintained, it can yield better results and help anyone to cope up with any unseen financial strain. The goal is always to preserve our money judiciously and not letting it sink.

[i]https://www.investopedia.com/terms/s/sinkingfund.asp

[ii]https://corporatefinanceinstitute.com/resources/knowledge/finance/sinking-fund/

[iii]https://www.wallstreetmojo.com/sinking-fund/

[iv]https:// www.business-case-analysis.com