Sinking funds are commonly used by companies in order to set aside enough money to pay off the bonds that they have issued. This type of fund carries with it some advantages and disadvantages for investors. Here are a few of the pros and cons of sinking funds.
The basic idea behind a sinking fund is that companies are trying to address their debt in advance. Instead of waiting for all of the bonds that have been issued to mature, they are going to set aside a certain amount of money into the sinking fund each year. They will use some of the money in the sinking fund to purchase a few of the bonds early.
As an investor, it is good to know that the company is going to be able to address its debt. You do not want to be a bond holder in a company that cannot afford to pay back the bonds that it issued. If this is the case, you may not be able to get your initial investment in the company back.
Investors like to see sinking funds in the companies that they are planning on investing in. This provides some peace of mind to the investors because they know that the company is not going to go under anytime soon. When a company lets its debt get out of control, it starts to become a much less attractive investment. No one wants to put money into a company that looks like it stands the risk of becoming insolvent in the near future.
The sinking fund also provides a few disadvantages for investors as well. When a company utilizes a sinking fund, they are going to periodically use the money to purchase some of the bonds early. If you are an investor that owns one of the bonds that is being purchased, it means that you are going to be giving up your interest payments.
Another problem with this type of fund is that the company has the right to purchase the bonds at a discount. Most the time, they can purchase the bonds at the par value. Many times, companies will wait until interest rates go down so that the values of the bonds will increase. At that point, they will purchase several bonds at the par value which would actually be less than what they would have to pay for them in the market.
If you are a bond holder in this situation, you are potentially going to have to lose money. If you would have sold your bond in the secondary market shortly before it was purchased by the company, you could have made a greater profit.
This situation creates a lot of uncertainty for investors. You never really know when your bonds are going to be purchased back from the company and your investment will end. Because of this, it can sometimes be difficult to justify investing in these bonds.