Sinking Funds

Sinking fund definition

Large corporations, government agencies, and other bond issuers typically must maintain a ready supply of cash in order to meet the financial obligations created by the bonds. To understand the purpose of sinking funds, it is necessary to consider the way that bond issues work; essentially, bonds are a long term loan taken out by a company, municipality, or governmental agency. Loan purchasers provide the issuer with immediate funding and are repaid with periodic interest payments and, at the bond’s full maturity, with the return of the principal investment as well. Thus, the company or institution must be financially prepared to return the investment when the bond matures. Establishing a sinking fund allows companies to set aside the money needed to ensure that bond obligations are met and the terms of the indentures are honored.

Sinking fund provisions

Companies often include clauses in the bond indenture that allow them to repurchase the bonds prior to maturity or at a specific price. Expenditures from sinking funds are used to repurchase these bonds at times that are favorable to the company, allowing it to pay down debt. While the presence of a sinking fund tends to make the company’s bonds more attractive to investors due to the lower risk of default, the call option that essentially exists on sinking fund bonds tends to make these securities less attractive to many investors.

Sinking fund formula

Typically, the sinking fund formula is derived by multiplying the total amount borrowed by the interest rate, then dividing the product by 1 plus the interest rate and taking that result to the power of the number of periods being considered, and at last subtracting one from the final result, as in:

• R = Ai/(1+i)n -1

where R = the periodic payment required, A = the total amount borrowed, n = the number of periods, and I = the interest rate. Sinking fund calculations often involve variables specific to the bond issue and the company, so this formula may be tweaked or changed depending on the specific situation under review.