SINKING FUND

To raise funds for expansion, product development, research, and other purposes, companies some times borrow money by issuing bonds, which are long-term promissory notes issued by companies to investors. Bond agreements or indentures generally require corporations to make regular interest payments—often semiannually—during the term of the bond. Corporations then must pay the maturity value or face value—the amount an investor initially paid—on the date of maturity. In addition, a bond agreement may contain a sinking fund provision that requires a corporation to repay a certain number of bonds in certain years, or for a corporation to retire part of a bond issue annually until fully repaid.

Traditionally under a sinking fund provision companies retired bonds by creating a special fund. Funds were transferred to a trustee who set up the fund and retired the bonds. Such arrangements, however, are not as common nowadays. Instead, the sinking fund provision simply refers to a company's obligation to buy back a certain number of bonds each year. The retirement of bond debt under the sinking fund provision may take the form of either paying a price at or above the face value of the bonds—which is referred to as calling the bonds—or buying them in the open market. Once in a while, a company will create a fund by transferring money to a trustee who invests it and initially uses money plus interest to retire the bonds once they mature.

A sinking fund provision may require either uniform annual payments, uniform increments over time, or contributions determined by the level of earnings. Since a bond issue with a sinking fund provision is generally considered to be safer than a similar bond issue without one, a sinking fund provision has the effect of lowering the interest rate on a bond issue. Consequently, a sinking fund provision is a trade off between safety and profitability from the investor's perspective.

A sinking fund may be illustrated as follows: if a company issued $10 million of tenyear bonds on June 1, 1990, with a sinking fund provision, it might have to retire 10 percent or ($1 million) of the bonds each year beginning in 1991 through June 1, 2000, when the bonds mature. Alternatively, since sinking fund provisions vary greatly, the company might have to retire 5 percent annually beginning in 1995.

BENEFITS OF A SINKING FUND

Sinking funds carry some risk, because failure to fulfill sinking fund requirements puts the bond issue into default, which might lead to bankruptcy. Hence, sinking funds might cause cash shortages. Nevertheless, an issuer may accept sinking fund provisions for the following reasons:

1. If the creditworthiness of the issuer is in question, lenders may not grant credit witho ut a sinking fund since it provides a measure of protection for the creditor. The opportunity costs of the sinking fund requirement may be the inability to secure long-term debt needed to purchase highly profitable equipment.
2. The accumulation of funds in a special account also provides the issuer with security against future business conditions that may be detrimental to its ability to retire the debt.
3. The insurance provided by a sinking fund decreases the interest rates, therefore, the interest expenses. This results in increased cash flow.
4. When the purchase of productive assets requires a sinking fund, the sinking fund mirrors the depreciation schedule of those assets. The issuer benefits in two ways. Depreciation allows the issuer to recover the costs while simultaneously retiring the debt of equipment going out of service.
5. The issuer can book capital gains on debt retirement if it purchases bonds in the open market below book value.
6. A sinking fund enhances the tax benefits of financial leverage. First, interest expense and depreciation are tax deductible. The issuer can use the tax savings to fund part of the annual sinking fund payment. Second, the sinking fund could earn compounded interest, helping to reduce the cost of borrowing. Finally, the interest expense decreases proportionately to the amount of bonds outstanding. If the sinking fund accumulates and compounds, the earnings grow geometrically. At some point the issuer will benefit from a positive after-tax cash flow.