A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. It is an account that is used to deposit and save money to repay a debt or replace a wasting asset in the future. It denotes a fund, which is created by setting aside certain amounts every year out of profits to meet a specific loss or debt at the end of a given date. It helps companies that have floated debt in the form bonds gradually save money and avoid a large lump-sum payment at maturity.
“A sinking fund is established so the company can contribute to the fund in the years leading up to the bond’s maturity.”
The term sinking fund refers to assets and their earnings earmarked for a specific purpose. A company that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship of a large outlay of revenue. It may help pay off the debt at maturity or assist in buying back bonds on the open market. 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 its obligations. The owner of the account sets aside a certain amount of money regularly and uses it only for a specific purpose. This concept appears in personal finance, as well, when individuals periodically set aside funds for specific future use, such as purchasing holiday gifts, taking a vacation trip, or building an addition to a house.
Advantages of sinking funds
- Brings in investors: Investors are very well aware that companies or organizations with a large amount of debt are potentially risky.
- The possibility of lower interest rates: A company with poor credit ratings will find it difficult to attract investors unless they offer higher interest rates.
- Stable finances: A company’s economic situation is not always definite, and certain financial issues can shake its stable ground.
A sinking fund is established so the company can contribute to the fund in the years leading up to the bond’s maturity. It is a type of fund that is created and set up purposely for repaying debt. It 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. It is a fund set up and accumulated by usually regular deposits for paying off the principal of debt when it falls due.