What is Bond Sinking Fund?

Explanation

It is an Escrow Account maintained by the company for the exclusive purpose of retiring the bond issued, and the company places cash in the same at specified periods. This account is managed and administered by an Independent Trustee.

As many such companies with less than desirable credit ratings raise money through the issuance of BondsIssuance Of BondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more by creating such a Bond Sinking Fund.

  • It requires the Issuer (i.e., the company raising funds) to set aside money periodically for the exclusive purpose of redeeming or buying back the specific Bonds for which the fund has been created.The issuer is required to make a deposit/ contribution in the Bond Sinking Fund, which is managed by an Independent Trustee who is responsible for the management of the Fund, investment of funds with predetermined specific investment criteria, and is also entrusted with the responsibility to ensure that this fund is used only for the purpose for which it is formed.It acts as collateral and makes sense in the case of Issuers, who are considered relatively riskier. As such, the investors who wish to subscribe to the Bond Issue of such Issuers need extra incentives and a safety cushion to avoid the risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more.Also, it acts as a security for the Investor in the unlikely event the issuer fails to repay or defaults in repayment. The Investor can get some portion of their funds (if not all) from the Bond Sinking Fund, which is managed by Example.

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Example

Let’s understand the same with the help of an example:

ABC Company sells a Bond Issue with a $100 face value and five years to maturity. The Bond carries a coupon of 5% and is redeemable at par value at the end of 5 years on its maturity. Accordingly, ABC Company will pay a coupon payment of $5 per year and will have to repay the entire $100 on maturity.

To avoid any cash flow problem that may arise on account of repayment of the entire principal amount at the end of 5 years of the Bond, the agreement requires ABC Company to create a Bond Sinking Fund and pledge specific assets to the fund, which will be exclusively available to pay off bonds at all times. Further, ABC Company is required to contribute a specified amount to the Bond Sinking Fund every year so that the company will face a smaller final cash outflow requirement at the end of 5 years when the bonds are due to be redeemed on account of maturity.

Why Bond Sinking Fund?

Bonds are usually issued for a longer time frame and pose greater interest rate riskGreater Interest Rate RiskThe risk of an asset’s value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more and risk arising on account of default in repayment of the principal amount on maturity due to strain on the company’s financial health. It acts as a cushion for the issuer, resulting in a substantially lower amount required to discharge the principal repayment on maturity and the investor by acting as a safety cushion.

However, it is pertinent to note that not all Corporations raising funds through Bond Issue are required to create a Bond Sinking Fund; however, bonds with sinking funds are viewed as relatively less risky by the Investor community.

This Sinking Fund is governed by the terms of the Bond Agreement and helps the issuer in different ways in the repurchase of Bonds, such as:

  • Periodic Repurchase of Bonds from the open marketPeriodic repurchase of Bonds at a specific call priceCall PriceA call price (CP) is the amount an issuer pays the buyer to buyback, call, or redeem a callable security before it matures.read more or lower than the Market priceRepurchase of Bonds at maturity

Advantages

  • It reduces default risk for the Investor as it leaves less principal outstanding at the time of maturity for the Issuer Company, thereby reducing the chances of default for the Investor.From the Issuer perspective, Bond with the Sinking FundSinking FundThe sinking fund bonds are defined as the bonds wherein the bond issuer specifically keeps a set defined amount to repay the holders of the bonds on the date of maturity or predefined dates. It is basically a bond made by the issuer to be catered as collateral if in case the issuer defaults on its payments to the holders of the bonds at a defined future date.read more is usually issued with lower coupon rates due to the additional safety cushion offered by the Issuer to Investor.From the Issuer’s perspective, it can result in booking Capital gains if Bonds are purchased in the open market below Book Value due to market conditions.

 Disadvantages

  • Bonds with Sinking Fund result in a limited upside for Investors due to the mandatory redemption associated with provisions of such funds.From an Issuer perspective, the opportunity cost of the Bond Sinking Fund requirement leads to the inability of the business to raise the long-term debt needed for profitable long-term gestation projects.

Accounting Treatment of Bond Sinking Fund

It is a long-term asset that is created solely to retire bonds. It is reported in the Asset section of the Balance Sheet under the Long Term Asset Head within the Investment classification. It is not classified under Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more as that will result in misconception among investors regarding the usage of the Bond Sinking Fund and lead to improved Current Assets and resulting Current Ratio, which may not be the case.

Conclusion

Bond Sinking fund provisions are governed by the terms and conditions of the Bond Agreement and act as a source of safety for the investors of such Bond Issuance. It also results in a lower interest rate the Issuer offers on the safety offered. Further, this Sinking fund requires upfront pledging of assets in the Fund or uniform annual payments or contributions into the fund, administered by an Independent Trustee. Thus it is a tradeoff between safety and profitability from an Investor’s perspective and is more attractive to risk-averse investors. On the contrary, money set aside in Bond Sinking Fund by the Issuer is not available for the company’s growth or for payment of dividends, which directly impacts the Issuer Company’s Stockholders adversely.

Bond Sinking Fund Video

This has been a guide to what is Bond Sinking Fund. Here we discuss its definition, advantages, disadvantages, and accounting treatment of Bond Sinking Fund, along with practical examples. You can learn more about Fixed Income from the following articles –

  • Sinking Fund FormulaCoupon Rate of a BondBonds vs. Debentures DifferencesBond Equivalent Yield