The financial accounting term bond sinking fund is used to describe cash that is set aside by a company, which is to be used to repay money owed to bondholders. A bond sinking fund is typically overseen by a trustee, who is responsible for the repurchasing of maturing bonds on the open market. A bond sinking fund is a corporation’s noncurrent asset that is restricted for the purpose of redeeming or buying back its bonds payable. Bonds that require a bond sinking fund will mean less risk for the bondholders.
These amounts appear on tax forms and either raise the amount of taxes paid by the investor (for gains) or lower the amount of taxes (for losses). A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. The sinking fund provision is really just a pool what is the difference between negative assurance and positive assurance of money set aside by a corporation to help repay previous issues and keep it more financially stable as it sells bonds to investors. A bond sinking fund is an escrow account into which a company places cash that it will eventually use to retire a bond liability that it had previously issued. There are several ways in which a sinking fund can be used to repurchase bonds.
- In effect the issuer of the bond holds 10 European call options on 1 million at 4% each.
- The investments section appears immediately after the current asset section.
- To calculate the annual cost of the bond debt, you combine both the annual bond interest payments and annual bond sinking fund payments into a single formula.
Since a sinking fund adds an element of security and lowers default risk, the interest rates on the bonds are usually lower. As a result, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt. Good credit ratings increase the demand for a company’s bonds from investors, which is particularly helpful if a company needs to issue additional debt or bonds in the future. When a company agrees to set up a bond sinking fund, this implies that it originally raised cash for a specific purpose that has a termination date, and so does not intend to roll forward the debt with a replacement bond issuance. The implication is that company management is using its funds in a conservative manner, rather than pushing a liability further into the future. This action also implies that the company may not find it necessary to issue bonds again in the future.
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To ensure the repayment of the principal, some bond agreements require that the issuing corporation create and maintain a sinking fund. These include repayment of the bond at maturity, early extinguishment of the debt before maturity, and conversion of the bond into common stock. Setting aside money to pay off debts is a prudent financial decision for companies to manage their obligations when debt comes due. Companies that don’t, may struggle to find the capital to make good on their outstanding debt obligations. Companies that are capital-intensive usually issue long-term bonds to fund purchases of new plant and equipment.
- The bonds usually have a provision that allows them to be repurchased at the prevailing market rate.
- All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
- If the investor holds onto the bond until maturity, the investor receives the full redemption price of $1,000.
- A sinking fund offers alternative protection for investors so that companies can offer lower interest rates.
However, the company first needs to foresee its financial obligations if it issues the bonds. How much interest will the company need to pay out to its bondholders annually? What annual sum will it deposit into the sinking fund to satisfy the provision? How does the liability side of the company’s balance sheet reflect the fund’s provisions? All these questions need to be answered so that you can make an informed decision.
Oil and gas companies are capital intensive because they require a significant amount of capital or money to fund long-term operations such as oil rigs and drilling equipment. Sinking funds have appeared throughout history, mainly as ways for sovereign governments to help repay war bonds and reduce national debts. Some of the earliest mentions date back to middle-ages Italian city-states, but the sinking fund concept is often attributed to efforts by the English crown during the 17th and 18th centuries.
Benefits of a Sinking Fund
As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate. The prospectus for a bond of this type will identify the dates that the issuer has the option to redeem the bond early using the sinking fund. While the sinking fund helps companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use the funds to repurchase preferred shares or outstanding bonds. A sinking fund helps companies that have floated debt in the form of bonds to gradually save money and avoid a large lump-sum payment at maturity. A sinking fund is a fund containing money set aside or saved to pay off a debt or bond.
Accounting for Retirement of Bonds
Paying the debt early via a sinking fund saves a company interest expense and prevents the company from being put in financial difficulties in the long term if economic or financial conditions worsen. Each year, the Bank of Montreal pays $510,000 in interest to its bondholders. Thus, the annual cost of the bond debt is $670,706.54 every year for the next 30 years. Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year. The sinking fund is a type of fund that is generally placed under the control of a trustee or agent who is independent of the entity that established the fund.
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On the other hand, an emergency fund is set aside for an event that is not known but can happen anytime. For example, one keeps a certain amount as an emergency fund that can be spent on a car accident, which is something that can never be predicted.
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Let’s say for example that ExxonMobil Corp. (XOM) issued $20 billion in long-term debt in the form of bonds. The company established a sinking fund whereby $4 billion must be paid to the fund each year to be used to pay down debt. By year three, ExxonMobil had paid off $12 billion of the $20 billion in long-term debt. If interest rates decline after the bond’s issue, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature.
However, investors may have concerns over the bonds being redeemed before maturity, as they will lose out on interest income. Potential investors are requiring that ABC establish a bond sinking fund into which ABC will make annual deposits of $500,000. An independent trustee will invest the corporation’s annual deposits with the goal of the sinking fund balance growing to approximately $20 million by the time the bonds come due in 20 years. By purchasing the bond at a discounted price of $9,475.79 and holding it until maturity, when it has a redemption price of $10,000, Baseline Industries earns a $524.21 capital gain.
In some cases, the stock can have a call option attached to it, meaning the company has the right to repurchase the stock at a predetermined price. In other words, the amount owed at maturity is substantially less if a sinking fund is established. As a result, a sinking fund helps investors have some protection in the event of the company’s bankruptcy or default.
Definition of Bond Sinking Fund
The disadvantage of a sinking fund is that it limits the availability of cash on hand for a business. This limited cash reduces the ability to invest, and therefore, earn a return. A callable is typically called at an amount slightly above par value and those called earlier have a higher call value.
It is also one way of enticing investors because the fund helps convince them that the issuer will not default on their payments. Par value is the amount of money a holder will get back once a bond matures; a bond can be sold at par, at a premium, or at a discount. The coupon rate is the amount of interest that the bondholder will receive per payment, expressed as a percentage of the par value.