Despite its dismal-sounding name, a sinking fund actually confers advantages to bond investors. A sinking fund is money or negotiable securities set aside for the purpose of redeeming debt. Bonds backed by a sinking fund are less likely to default on interest payments and repayment of principal, making them safer investments and more attractive to risk-averse investors. Corporations often employ sinking funds when they want to retire a bond issue in installments.
Advantage One: Risk Reduction
Corporations sometimes go bankrupt. When this occurs, bondholders and the government get priority access to the proceeds of liquidation. However, not all bonds get equal access. The pecking order for payoff begins with senior bonds backed by some asset of the company. For bonds backed by a sinking fund, the fund balance, if any still exists, can be claimed exclusively by the holders of the backed bonds. There is no guarantee, however, that a corporation on its way to bankruptcy hasn’t dipped into a sinking fund for unrelated reasons.
Advantage Two: Lower Interest Payments
A corporation can use a sinking fund to retire a bond issue a portion at a time. For example, a sinking fund for a 10-year bond may buy back 10 percent of the bonds each year, thereby reducing interest payments by a like percentage. The remaining bondholders appreciate the lower interest payment obligation, since it reduces default risk. Stockholders also like it, because expenses reduce net income and thus hurt stock prices.
Advantage Three: Higher Bond Prices
When a corporation redeems part of a bond issue ahead of the maturity date, it results in fewer bonds from that issue that are in circulation. Bonds prices are a function of supply and demand. All things being equal, a reduced supply of circulating bonds will drive up the price of the outstanding bonds, yielding potential capital gains to the remaining bondholders. Demand for bonds can change if prevailing interest rates move up or down; this effect may overwhelm the consequences of reduced supply on the bond’s price.
To Be Fair
Sinking funds carry a couple of disadvantages. Money set aside in a sinking fund is not available to grow the company or pay dividends -- a disadvantage to stockholders. Additionally, early redemption is facilitated by a sinking fund, which reduces the number of interest payments a bondholder receives. If interest rates are lower when the bonds are redeemed, the bond investor may not be able to obtain a source for the same interest income as that paid by the redeemed bond.
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