Perhaps the first thing that springs to mind when you hear the phrase “sinking fund” is a pirate ship going down with a load of gold on board. However, that is not the topic at hand including sinking funds in your overall financial plan is a smart move. Essentially, a sinking fund is a type of savings account that serves a specific goal and takes a unique strategy.
The term “sinking fund” refers to a savings account used for a future fixed cost. A sinking fund is set up with a specific goal, unlike a traditional savings account or an emergency fund, whether for a vacation, a down payment on a home, or any other significant expenditure. To help astrologers save money, financial instructor Haley Sacks set up a special “sinking fund.”
Having a sinking fund ready to go might be a massive relief if you’re trying to save for a large, unexpected bill.
Let’s have a discussion about what a sinking fund is, how it operates, and why it should be a priority in your financial planning.
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What Is a Sinking Fund?
Money explicitly accumulated for the purpose of retiring a bond or other kind of debt is deposited into what is known as a sinking fund. Companies that issue debt eventually have to pay it off, and the sinking fund reduces the immediate impact of this massive cash outlay. Establishing a sinking fund allows the issuer to make payments into a savings account in preparation for the eventual redemption of the bond.
How a Sinking Fund Works
Companies that have issued bonds to raise capital can use a sinking fund to save for the eventual redemption of those bonds without having to come up with a huge sum all at once. Bonds may include a sinking fund provision at their issuer’s discretion. The bond’s prospectus will detail the times the issuer can exercise its right to redeem the bond early out of the sinking fund. In addition to ensuring that there will be enough money to pay off debt, a sinking fund can also be used to repurchase preferred stock or bonds.
Lower Default Risk
Incorporating a sinking fund into a bond offering gives potential buyers more peace of mind. Bonds are less likely to default on their payments at maturity if money is set aside to do so. In other words, the final payment will be far lower if a fund is in place. Therefore, a sinking fund aids investors in mitigating their losses in the event of corporate insolvency or default. More investors will be interested in purchasing bonds issued by the company if there is less of a default risk, which can be accomplished with a sinking fund.
Creditworthiness
Reduced default risk and security are two reasons sinking funds result in lower bond interest rates. This means that investors are more likely to give the company a good grade for its debt. If a business requires to issue more debt or bonds in the future, it will benefit significantly from having a high credit rating, as this will raise demand from investors.
Financial Impact
Because of the decreased default risk and increased security provided by sinking funds, bond interest rates are reduced. This means creditors are more inclined to grant the firm a high rating. A high credit rating can help a company attract more investors to its debt and bond offerings in the future.
Callable Bonds
Bonds that can be called give the issuer the option of retiring all or a portion of the bonds early through the use of the sinking fund. The issuer of the bonds has the opportunity to “call” or repurchase the bonds at any time. The terms of the callable feature, such as the price and quantity of bonds that are callable, can be found in the bond issue’s prospectus. A random selection of bond serial numbers is used to determine which bonds are callable.
A callable is a bond that can be redeemed for a sum slightly higher than its face value, with the call value increasing for bonds that are redeemed sooner. For instance, if a bond is callable for 102, the investor would receive $1,020 for every $1,000 in face value; however, the terms can stipulate that the price drops to $1,010 after a year.
The bond issuer will be able to issue new debt at a lower interest rate than the callable bond if interest rates fall after the bond is issued. Using the funds from the secondary offering, the corporation redeems the callable bonds at face value. Therefore, the corporation has refinanced its debt by exchanging the higher-yielding callable bonds for the newly-issued debt at a reduced interest rate.
Bonds’ face value would be below market value if interest rates dropped, as this would cause bond prices to rise. In this scenario, the corporation can ” call” the bonds and redeem them from the investors for face value. There will be reduced long-term revenue for the investors due to the loss of interest payments.
Other Types of Sinking Funds
Preferential stock may be repurchased with sinking fund money. The dividend paid on preferred stock is typically higher than that paid on common stock. A sinking fund is a pool of money that can be used to buy back preferred shares at a discount. The stock may come with a call option, which allows the business to repurchase the security at a specific price.
Business Accounting of Sinking Funds
On a company’s balance sheet, a fund will often be included with the listing for long-term investments because it is considered a noncurrent or long-term asset.
Long-term bonds are commonly issued by capital-intensive businesses to finance the purchase of new machinery and other physical assets. Capital-intensive describes the nature of oil and gas businesses due to the high costs associated with maintaining oil rigs and other drilling equipment over the long term.
Real World Example of a Sinking Fund
Example: ExxonMobil Corp. (XOM) has issued US$20 billion in long-term bonds. Bondholders were to receive interest payments semiannually. In order to reduce debt, the corporation has established a sinking fund that requires annual payments of $4 billion. At the end of the third year, ExxonMobil had repaid $12 billion of the total $20 billion in long-term debt.
The alternative to creating a sinking fund was for the corporation to pay down the debt in year five by using $20 billion of its profit, cash, or retained earnings. On top of paying off the debt, the corporation would have incurred interest costs for the next five years. Exxon could have run into trouble making its loan payment if the economy had taken a turn for the worse or if the price of oil had plummeted.
Interest costs can be reduced, and long-term financial stability can be protected by using a sinking fund to pay off debt early. ExxonMobil has the ability to raise additional capital through borrowing, thanks to the sinking fund. We can continue with our hypothetical above and assume that by year three, the company needed to issue another bond in order to raise funds. With only $8 billion in debt remaining out of the original $20 billion, the corporation has shown a consistent ability to repay debt ahead of schedule and potentially borrow further cash.
The emergency savings account is typically seen as the financial lifeline of the last opportunity. The absence of sinking savings may be to blame if you have an emergency money but are still having trouble making ends meet, even though it has been a while since you had to tap into it.
A sinking fund is a savings mechanism used to pay for unforeseen but necessary costs. They can make it possible for you to spend money on events and accidents that would otherwise be out of the question.
Make an excellent financial move and start a sinking fund right away. Whether planning to make a long-term investment or anticipating an equally crucial payoff of debt, you can rest easy knowing that your sinking fund has you covered.
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Read more: Funds & Loans
Source: Investopedia