The Advantages of a Sinking Fund for Bonds

by Jack Ori

Some long-term investments, such as municipal bonds for school districts, contain sinking fund provisions. A sinking fund requires the bond issuer to pay a certain amount into a trust fund each year. The trustee of the sinking fund can then buy back bonds on the open market or via a lottery. By the time the bond matures, the trustee should be able to repay the principal on the bond even if the company does not have enough money to pay it.

Guarantees Payment

Sinking fund provisions help guarantee investors that the company will repay its principal on the bond. If a bond has a sinking fund provision, the company must make payments to a trustee every year after a grace period. The trustee can then use these funds to repay investors for bonds that have reached maturity. Thus, a sinking bond provision guarantees that eventually the investor will get his investment back.

Locks In Interest Rates

Sinking bond provisions lock in the interest rates on the date the investor purchases the bonds. The company must pay the trustee each period based on that interest rate. Thus, if interest rates rise, the trustee can re-purchase the bonds on the open market at a discount, making it easier to retire the bonds and repay investors. If interest rates fall, however, it may be more difficult for the trustee to repurchase the bonds in the open market.

Lower Cost of Debt

Since sinking fund trustees must use funds to repurchase bonds or otherwise retire them, their transactions may help keep the value of the bonds slightly higher than it otherwise would be. If this happens, it lowers the total cost of the company's debt, thus making the company's stock worth more overall.

Considerations

Sinking funds are more advantageous for investors than for the company selling the bonds. Although investors are more likely to invest in these bonds, the bond issuer must make payments to the trustee every year, which can cut into its assets. In addition, sinking fund bonds often take 20 to 30 years to mature, so investors may not see the advantages for a long period of time.

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