Sinking Fund

Quick Summary of Sinking Fund

A fund into which a company sets aside money over time, in order to retire its preferred stock, bonds or debentures. In the case of bonds, incremental payments into the sinking fund can soften the financial impact at maturity. Investors prefer bonds and debentures backed by sinking funds because there is less risk of a default.

Some corporate bonds and most preferred stock have sinking fund provisions. These require the issuer to set aside funds and retire a specified amount of the outstanding securities each year. Securities can be retired in two ways:

• Securities may be purchased in the secondary market and then retired.
• Securities may be called. Usually, the call price is the security’s par value. The specific securities to be retired each year are determined by a random lottery.

Sinking fund schedules vary. They generally require that a fixed number of securities be retired each year. For preferred stock, retirements continue until the entire issue has been retired. For bonds, anywhere from 20% to 100% of an issue will be retired prior to maturity. The issuer may have options to postpone retirements for the first few years or to accelerate retirements. The latter option may be used by a bond issuer to refund some bonds that otherwise would not be callable.

Sinking funds serve different purposes for preferred stock and bonds. For preferred stock, they transform the securities from permanent capital to a form of long-term funding comparable to a corporate bond. Unlike corporate bonds, the preferred stock retains the flexibility to skip some dividend payments.

For bonds, a sinking fund provides investors with assurance that the issuer will be responsible for setting aside earnings and retiring the debt. Failure to do so would mean that all the bonds’ principal would come due on the maturity date. This could pose liquidity risk, especially if the issuer’s credit quality declines in the interim. For this reason, the failure of an issuer to honour a sinking fund provision constitutes a default.

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