Question

How and why do sinking funds enhance the safety of lenders?

Answer 1

A sinking fund is a fund that a company makes periodic payments to in order to pay off debt capital. The fund could be in the form of preferred stock, cash, or other bonds, but the money will always go toward fulfilling the par value of the bond at its maturity date.

Sinking funds lower bonds’ default risk. This is a benefit for lenders–they can be assured that the company is putting money toward paying off their investment. The value of the bond may also go up, giving the lender the option to sell the bond at a price higher than par value, or the original amount they paid.

There is a risk, however, that they may have to sell their bond back to the company before its maturity date, therefore ceasing to gain interest. This comes into play when a call feature is written into the sinking fund provision. The call feature allows the company to buy back a certain amount of the bonds it has issued at random, using a lottery system to choose random bond serial numbers to identify which ones to buy back. Unlucky investors whose bonds are chosen through this system must sell their bonds back to the company at either par value or the current market price, whichever is lower.

Sinking funds put companies at an advantage in that they improve their creditworthiness, allowing them to pay investors at a lower interest rate. A company with bond sinking funds is more appealing to lend money to because there is less default risk, or chance that it will not be able to pay off investors. Sinking funds can make a company more trustworthy and their bonds more secure

On the flip side, sinking funds may also disadvantage companies that could make better use of that money elsewhere. Putting money into sinking funds means it can’t be used to fund growth, making company stock less appealing to investors