The Advantages & Disadvantages of a Sinking Fund

by Walter Johnson

There are many advantages to financing through debt. A “sinking fund” is a body of assets used to pay back these bonds. Buying bonds can be a very profitable investment for a firm if they can time the market properly. Debt financing means that those who have bought your bonds have a claim on your assets, but they have no control over the firm.

Profits

Money has value. It has value that is reflected by the present and expected rates of interest. If a firm believes that rates will fall in the future, it will sell bonds and use a sinking fund to eventually pay back these debts. Normally, under these conditions, the fund itself will be made up of other bonds that take advantage in the drop in rates. The basic advantage of a fund is to have a ready pool of cash on hand to pay investors. This cash, represented in bonds, can either rise or fall in value depending on rates.

Firms

A sinking fund is an advantage to firms only if rates will fall. This is because if rates rise in the future, the bonds you issue today will be worth less. If you can make 5 percent from a bond tomorrow, and are holding a 4 percent bond now, you will naturally want the former over the latter. Supply and demand dictate then that the 4 percent bond you hold now is worth that much less. It is no longer in demand. If the firm then has a sinking fund, it can buy more bonds that will earn more money then it has to pay out in debt payments. A sinking fund, therefore, has the advantage of acting as a profit maker for a firm while financing the firm's expansion.

Investors

Investors will not buy corporate bonds if they believes rates will rise. If a firm issues bonds believing that rates will fall, and instead they rise, the firm is in trouble. It has received the financing it needs, but it now is faced with investors holding bonds against itself that are worth more than when they were issued. In some cases, the firm will call in the bonds, if that option is available, so as to minimize loss. The main disadvantage of a sinking fund can only exist if the company issuing them misreads market trends. On the other hand, investors feel safer if a firm has a fund that can be used to pay them regardless of what happens to rates.

Markets

A sinking fund can encourage investment in a firm because its very existence reassures investors. A savvy investor, however, might see a corporate sinking fund itself as a signal that the firm expects rates to fall. Thus, the advantage of a sinking fund to either the corporation or the buyer really depends on the nature of the investor. If the investor is a gambler, he can bet on rates rising and hence, make more money from his initial investment. If an investor wants a safe bet, then a sinking fund might be reassuring, but it can also signal the firm's desire to buy paper that will soon become cheap.

References

  • "Fundamentals of Financial Management"; Eugene F. Brigham and Joel F. Houston; 2009
  • "Advanced Accounting"; M. Hanif and A Mukherjee; 2003

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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