Definition
A Bond Sinking Fund is a strategy used by companies to set aside money over time to retire its debt on maturity. This fund is a portion of the company’s earnings kept specifically to repay the principal amount of a bond issue. It helps to mitigate the risk of default, making the bond more attractive to investors.
Key Takeaways
- A Bond Sinking Fund is a reserve account set aside by the issuer of a corporate bond to ensure they can meet their future obligations to the bondholders. It reduces default risk and helps build trust among investors.
- By setting up a Bond Sinking Fund, the issuer repurchases some portion of the bond issue each year and retires it gradually, rather than waiting to retire the entire bond issue at maturity. This strategy helps in spreading out the re-payment burden across multiple years.
- The existence of a Bond Sinking Fund might be attractive to investors, as it reduces credit risk. However, it may also limit the bonds’ potential price appreciation, since part or all of the bonds can be redeemed by the issuer before maturity. This makes sinking fund provisions a double-edged sword for bond investors.
Importance
A Bond Sinking Fund is a critical financial instrument for both corporations and investors.
It represents a corporation’s strategic approach to managing long-term debt by setting aside a certain amount of money over time to ensure that bonds are paid off upon maturity.
This not only reduces the risk of default but also helps maintain a company’s creditworthiness.
For investors, it assures them that the issuing company is capable of meeting its future obligations.
Therefore, a Bond Sinking Fund contributes to financial stability and builds trust among investors, playing a major role in providing a secure investment environment.
Explanation
A Bond Sinking Fund serves an important purpose in long-term financial planning, primarily used by corporations to reduce the eventual burden of retiring corporate bonds at the maturity date. It is essentially an account where a corporation gradually sets aside funds over a predetermined period.
This gradual accumulation of cash ensures that the company is in a solid financial position to repay or redeem their bond obligations when they become due. The use of a bond sinking fund is an advantageous approach for a company as it helps prevent situations where large lump sum payments damage their cash flow or operations.
Instead, the regular contributions to the sinking fund represent a manageable and steady outflow. From an investor’s perspective, a bond associated with a sinking fund represents a lower risk investment.
That’s because the very existence of the fund shows the issuing company’s dedication to fulfilling its long-term commitments. This lowers default risk and often results in a higher bond rating, which is attractive to potential bond investors.
Examples of Bond Sinking Fund
Walt Disney Company: In 1993, the Walt Disney Company issued a $150 million bond for theme park expansion with a bond sinking fund provision. Rather than waiting until the end of the bond’s tenure to pay off the principle amount, Disney was required to make annual payments into the sinking fund, which was then used to retire a portion of the outstanding bonds each year.
AT&T Inc.: AT&T Inc., a leading telecom company, has frequently made use of sinking funds in their financing strategy. In 2009, they reported $3 billion in sinking fund payments to help repay a series of their outstanding bonds over time.
Verizon: Verizon, one of the largest telecommunication companies in the U.S., also has operated with a bond sinking fund. In 2010, they issued bonds with a value of $
25 billion and established a sinking fund to ensure timely repayment. This mechanism helped Verizon to manage their long-term liabilities and to retain the confidence of their investors.
FAQ: Bond Sinking Fund
1. What is a Bond Sinking Fund?
A Bond Sinking Fund is a fund set up by a bond issuer to repay part of the bond principal before the maturity date of the bond. This reduces the final payment on the maturity date and thus, the risk for the bondholders.
2. How does a Bond Sinking Fund work?
A small amount of money is set aside regularly in a separate account, the sinking fund account. The money in this account is then used to retire some part of the bond issue early. The sinking fund makes the bond less risky thereby decreasing the yield that investors demand out of the bond.
3. Are companies required to have a Bond Sinking Fund?
Not all companies are required to have a Bond Sinking Fund. It depends on the terms of the bond agreement at the time of the bond issue. Companies that want to make their bonds more attractive to investors often use sinking funds as a means of reducing default risk.
4. How is the early retirement of bonds achieved in a Bond Sinking Fund?
The early retirement of bonds in a Bond Sinking Fund can be achieved by two methods. The company either buys back bonds from the market at the current market price or uses a lottery system to retire the bonds at face value.
5. What are the benefits of a Bond Sinking Fund?
A Bond Sinking Fund benefits both the issuer and the bondholder. The issuer benefits from the possibility of reduced default risk and potentially lower interest payments. The bondholder benefits from reduced risk of default and the potential for early repayment.
Related Entrepreneurship Terms
- Debt Service Fund
- Callable Bond
- Amortization Schedule
- Corporate Bond
- Trustee
Sources for More Information
- Investopedia – An extensive resource for investing education, personal finance, market analysis, and free trading simulators.
- Accounting Tools – Provides articles and books of in-depth accounting and finance information.
- The Balance – A site that makes personal finance easy to understand. It is a resource for deciphering complex topics and gives understandable, practical advice about money.
- Corporate Finance Institute – A leading provider of online courses and certifications for careers in investment banking, equity research, corporate development, private equity, and other areas of corporate finance.
