What it means
A sinking fund is a pot of money that an issuer sets aside to retire its debt in stages instead of in one large payment at the end. Where the bond terms include a sinking fund, the issuer must make regular payments into it or buy back a set number of bonds each year.
The sinking fund call is the mechanism for the second approach: the issuer announces that a portion of the bonds will be redeemed. Investors usually value the feature because it lowers default risk.
Repaying principal gradually means the final repayment is smaller, which is easier for the issuer to meet. For this reason bonds with sinking funds are often priced at slightly lower yields than comparable bonds without them.
The call is nearly always at par, which means face value, whatever the bond is trading at in the market. If the bond trades above par, an investor whose bond is selected takes a small loss relative to the market price.
If it trades below par, the investor benefits, and issuers often prefer to buy bonds in the open market instead when prices are low. Many sinking fund provisions also allow the issuer to redeem more than the minimum.
Some give an option to double the required amount, which gives the issuer flexibility when it has surplus cash and wants to cut debt costs. Investors then face more uncertainty about how long their bonds will remain outstanding.
Finance teams account for the amounts due within a year as a current liability. They also need to plan the cash for each redemption date, because missing a required sinking fund payment can be an event of default.
The structure sits between a bullet bond, which repays everything at maturity, and an amortising loan, which repays steadily from the start.
In practice
Real-world examples.
Example
A utility company issues $200,000,000 of bonds with a sinking fund starting in year six. Each year it redeems $10,000,000 at par by lottery. Its treasurer schedules the cash in the annual budget so that the redemption never competes with capital spending.
Example
A retiree holds ten bonds from a manufacturing issuer that she bought at a premium for the steady income. She receives notice that her bonds were selected in the lottery and will be redeemed at face value. She loses the premium she paid and must find a new investment for the cash.
Example
A food processing company sees its bonds trading at $950 against a face value of $1,000. Instead of calling bonds at par, it buys the required quantity in the market at the lower price. The saving of $50 on each bond lowers its cost of meeting the sinking fund.
Formula
Calculation
Bonds called = Sinking fund payment / Face value per bond
Probability a given bond is called = Bonds called / Bonds outstanding
Suppose an issuer has 50,000 bonds outstanding, each with a face value of $1,000. The sinking fund requires a $5,000,000 redemption this year. Bonds called = 5,000,000 / 1,000 = 5,000 bonds. Probability for any one bond = 5,000 / 50,000 = 0.10, or 10%. An investor holding 10 bonds bought at $1,040 each would, if all were called at par, receive $10,000 against a cost of $10,400, a loss of $400.Case study
Seen in the real world.
Oakridge Packaging is an illustrative, fictional company that issued 20-year bonds to fund a new plant. Its lenders were nervous about a single large repayment, so the bond terms included a sinking fund beginning in year ten.
When the first redemption year arrived, interest rates had risen and the bonds traded below par. The finance director bought the required amount of bonds in the market at a discount rather than calling them at face value, saving the company a meaningful sum.
The illustrative takeaway is that the sinking fund call protects lenders but also gives the issuer choices. Understanding the exact terms lets a treasury team pick the cheaper route each year.
Watch out
Common mistakes.
- Assuming the issuer chooses which bonds are called, when selection is typically random so that no investor is favoured.
- Treating a sinking fund call as the same as an ordinary call option, when the sinking fund call is often an obligation rather than a choice.
- Ignoring reinvestment risk, because investors whose bonds are called must find a new home for their cash, possibly at lower rates.
Questions
People also ask.
Why do issuers agree to a sinking fund?
It reassures lenders that the debt will be repaid gradually, which can reduce the interest rate the issuer has to pay.
What price is paid when bonds are called?
Usually par, meaning face value, regardless of the current market price.
Is a sinking fund the same as a reserve account?
Not exactly: a sinking fund is dedicated to retiring specific debt, whereas a general reserve can be used for any purpose.
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