A sinking fund is a type of fund that is set up by a business in order to retire debt. A company will put money into the sinking fund and then periodically use it to pay off certain debts of the company. Here are the basics of the sinking fund and how it works.

Sinking Fund

This type of fund is most commonly used when companies issue corporate bonds. When a company issues a corporate bonds, they have to make regular interest payments to the bondholders. Most of the time, companies can afford to make these small regular payments to the bondholders. However, when it comes time to pay back the principal of the bond, they may not have enough cash on hand. The purpose of the sinking fund is to accumulate enough cash so that a company will be able to repay the debt at the end of the bond term. Many times, as companies accumulate extra cash in the sinking fund, they will go ahead and purchase some of the bonds in advance of maturation.

Impact to Investors

If you are a bond holder in a company that has a sinking fund, it could potentially affect your investment. With this type of fund, there is the chance that your investment could end at any point. The company could decide to purchase your bond back from you anytime without notice. If you were counting on the interest from this type of investment, you could potentially lose it at any point. 

Types of Sinking Fund

There are four different types of sinking funds that a company could choose to have. Even though all of the different types of sinking fund are similar, there are a few key differences between them. 

The first type of sinking fund sets out to purchase a specific amount of bonds back over the course of a calendar year. Every year, they will try to buy the same amount of bonds as long as they can accumulate enough cash to do so.

Another type of sinking fund utilizes callable bonds. With this type of arrangement, the company has a specific call price that it can purchase the bonds back at. 

The third type of sinking fund utilizes an option of how the bond is purchased back. The company can buy it back from the bond holder at one of two prices. They could decide to purchase it at the market price. They could also decide to purchase it back at the sinking fund price. The company will be able to purchase the bonds back at the lower of the two prices.

The fourth type of sinking fund makes regular payments to a trustee that hangs onto the money on behalf of the company. The value of the asset continues to increase until it matches the amount of the outstanding bonds. This strategy is not as common as the other two but it does happen in some cases.

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