Sinking Fund Bonds Definition

The independent trustee would then use the amount received from the company to invest it further in assets having long-term maturity. Such investment may be broken only to retire existing issues of bonds.

Types of Sinking Fund Bonds

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 #1 – Sinking Fund Bonds for Callable Bonds

Whenever there is a decrease in rates of interest, the company callbacks its bonds by buying them back from the holders at a premium. A sinking fundSinking FundSinking funds are funds that are periodically accumulated by the company as reserve. Later the reserve fund is used for a specific purpose—repayment of debts or repurchase of bonds on maturity. As a result, companies are not burdened with paying a huge sum at once.read more bond may help the company buy the bonds issued by providing the needful cash cushion for the company.

#2 – Sinking Fund Bonds for Aligned Purpose and Goals

The business may have incorporated certain goals and purposes for which it may require cash to service them in the future. The business may incorporate such a bond to service such goals in the upcoming future.

#3 – Sinking Fund Bonds for Buyback of Bonds

The business may look to retire its debt early. To cater to this goal, it may incorporate such a fund to cater to the buybacks of existing issued bonds from the holder of bonds.

Sinking Fund Bond Formula

It can be determined using the time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more relationship as described below:

Here,

  • The amount contributed regularly is represented by A.The rate of interest is represented by r.The time period is represented by n.

Examples of Sinking Fund Bonds

Example #1 – Numerical Example

The company holds a debt of $1 million at the rate of interest of 6% and with a repayment period of 5 years. The company plans to incorporate a sinking fund of $60,000 at the end of 5 years, with the rate of interest as 4%. The company must determine the periodic annual payments to formulate the sinking fund.

The Periodic amount would be determined as follows:

  • $60,000 = A * (1+0.04)^5 -1 /0.04$60,000 = A * (1+0.4)^5 -1 /0.04$60,000 = A * (1.2167 -1) /0.04$60,000 = A * (0.2167) /0.04$60,000 = A * 5.4163A = $60,000 / 5.4163 = $11,077.6

Therefore, the company must save $11,077.6 into the sinking account, which could then be utilized in the early or easy payment of the bonds.

Example #2

Suppose the company has issued callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond’s maturity. This right is exercised when the market interest rate falls.read more of $20 million at the rate of interest of 8 percent for ten years.  There has been a decrease in interest rate by 2 percent, and the updated rate of interest is at 6 percent. The company additionally maintains a sinking fund bond of $5 million.

The company may call the bonds back only to reissue them at a lower rate of interest. The company may utilize the sinking fund bonds to repay the call premium associated with the callable bonds.

Example #3 – Practical Application

Suppose the business has a debt worth $10 million to be paid off at the rate of a 6% rate interest after ten years. The company additionally faces a 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 as well as interest rate risk. To cater to such a situation and to handle their exposure, the company plans to incorporate a sinking fund bond wherein it plans to contribute $2 million annually for three years.

After the end of three years, the business would have $6 million to pay off the remaining debt payable after the end of three years.

Advantages

  • The sinking fund bonds, if used strategically, can be used to pay off debt and liabilities early.It also facilitates timely payments of debt obligations on the date of maturity.If the rates of interest decrease, then these bonds can be utilized to call back existing debt issues. It can be used to buy back existing bond issues from the holders of the bonds.Since there are early payments of debts, it enhances the goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company’s net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company’s net identifiable assets from the total purchase price.read more of the issuing business.

Disadvantages

  • From the perspective of investors, the holder of the bonds loses on the interest payments since their bonds were paid off early using sinking bond funds.The business may not retain its existing investor confidence since the issues were called back using sinking bond funds.

Important Points

  • The business employs sinking bond funds with a very low credit rating and bad credit profile.It is very risky for the investor to invest in such bonds as such bonds have high default risk.It may be used to buy back any pre-existing bonds in the open market.They are normally classified as a restricted assets for the issuing business.In the balance sheet, sinking bond fundsBond FundsThe bond fund, also known as a debt fund, is a mutual fund that invests in bonds and other debt securities, pays dividends periodically and does not possess any maturity date. It generates a stream of income by investing in fixed income securities like government securities, bonds, debentures.read more are recorded under the non-current assetNon-current AssetNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company’s investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more section with the account label Investments.Although these bonds are composed only of cash, they are never part of current assets as they have primarily been prepared to pay off long-term debtLong-term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more and not current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They’re usually salaries payable, expense payable, short term loans etc.read more.

Conclusion

Sinking Fund bonds are made when the issuing company has to safeguard itself from interest rate riskInterest 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 default risk. The sinking fund bonds are formed by the business which is not cash-rich. Rather, they are cash deficient and have strained financial health. They are normally visualized as collateral for the holder of the debt, which would be used by them when the company defaults.

The business may incorporate this bond under the supervision of a trustee. The trustee is an independent member that supervises the administration of such bonds. The trustee is required in such situations due to the larger size of sinking funds, and these funds have to be managed in the system so that they can be used to redeem the debt early.

This has been a guide to Sinking Fund Bonds and their definition. Here we discuss types and formulas to calculate sinking fund bonds along with examples, advantages, disadvantages, and limitations. You can learn more about fixed income from the following articles –

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