When comparing bond issues carrying equivalent risk, terms of the indenture detail the features. An indenture, which is the legal contract that outlines the provisions of a bond, will provide details as to the payment schedule and other terms. One provision that may be outlined in the agreement is the sinking fund. The presence of a sinking fund in an indenture holds some advantages for both the bond holder and the issuer. Understanding those advantages simplifies choosing between investment products.
A sinking fund provision in a bond agreement requires the firm issuing the bond to pay off a portion of company debt each year. The sinking fund may call for the firm to retire a certain percentage of a particular bond issue or a certain percentage of total outstanding debt. In addition, the reduction called for by the sinking fund provision may be outlined in terms of a set dollar amount, a fixed rate or a variable percentage.
Added security is an advantage to the investor who purchases a bond with a sinking fund provision in the indenture. Having a sinking fund requirement increases the chances that the principal will be returned, and it reduces the likelihood that the issuer will fail to pay as required.
Lower Borrowing Costs
Since many investors are naturally risk averse, lowering the risk of default on a bond entices consumers to invest in products with lower rates of return. Bond issuers who include sinking fund provisions in contracts can take advantage of lower interest rates, resulting in less cost to borrow. Bond issuers also take advantage of a reduction in overall interest rates in the market by retiring bonds with higher interest rates with sinking fund provisions, and issuing new bonds at lower rates.
Lower Buyback Rates
Bond contracts with a sinking fund provision often permit the issuer to buy back bonds at either the par value, the face value, or current market price. If a company's bonds are selling below par value, the firm may choose to redeem the bonds at market price. However, if the bonds are selling at a premium, the firm can choose to buy the bonds at par value. By reducing the amount due on a debt over time, a firm issuing bonds with a sinking fund does not have to payout as much at one time, thereby conserving working capital.
- "Finance: Investments, Institutions, Management"; Stanley G. Eakins, 2005
- "Investment Analysis and Portfolio Management"; Fifth Edition; Frank K. Reilly and Keith C. Brown; 1997
- University of Texas at San Antonio: Dr. Keith Fairchild, Lecture: Long-term Debt
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