Definition: A sinking fund is an account that is used to deposit and save money to repay a debt or replace a wasting asset in the future. In other words, it’s like a savings account that you deposit money in regularly and can only be used for a set purpose.
What Does Sinking Fund Mean?
What is the definition of sinking fund? Private and public corporations often use these funds for bonds. For example, a company might deposit money regularly in the fund to buy back bonds each quarter before they mature. This helps build investor confidence that the company will not default on their obligations.
They can also be used in reference to capital expenditures and renewals by saving funds for larger fixed asset purchases in the future.
Firms establish a sinking fund to ease the process of retiring debt or prevent defaulting on debts. It can serve several purposes but the main purpose is to lower the outstanding principal before it becomes due. Creditors regard these funds in a favorable light, because firms that use the fund reduce the risk of default when the principal is due; so basically, it reduces credit risk.
A distinguishing aspect of a fund is the payment structure. The payments into it are set in a way that that it amortizes the forecasted or expected expenditure.
Let’s look at an example.
Example
Lori’s Lamps issues $100,000 of bond to start a new store. Since the issuance, Lori created a fund by regularly depositing $1,000 in it to pay off the principal.
Now, Lori plans to repurchase 50 percent of its $100,000 outstanding bonds in the open market this year to lower the principal balance it will owe at maturity. Since interest ratesincrease and decrease over time, the price of the bonds might increase or decrease. Obviously, Lori doesn’t want to purchase the bonds for more than their face value, so she included a sinking fund provision in the original issuance.
This means that Lori can either purchase the bonds back at random for the market price or the face value, whichever is lower. Thus, Lori randomly chooses bonds to repurchase based on their serial numbers. While purchasing these bonds will lower the outstanding principal, there can be limitations on the amount or percent of bond issues that can be repurchased per the fund provisions.
After Lori recalls the bonds, she will have effectively lowered the outstanding principal to $50,000. Thus, she spread the principal payments over a period of time to dampen the effects of a large principal payment on the maturity date.
Summary Definition
Define Sinking Funds: Sinking fund means a way for a company to pay off a portion of its bond issuance before it reaches maturity by saving money in a separate account and purchasing back bond incrementally before they mature.
