Sinking Fund

A great way to diversify your investment portfolio

Sinking funds are a great way to diversify your investment portfolio. They are similar to savings accounts, but they serve a different purpose and take a different approach. 

Sinking Fund

These funds are intended to allow you to set money aside in anticipation of a future expense. This is usually a one-time expense, such as a planned vacation, a down payment on a home, or a large-ticket purchase. 

By setting up this type of fund, you can allocate money and plan ahead for upcoming expenses, which can help reduce financial stress. 

This is a safe, secure, and liquid savings account set up for a specified future cost. It can be used for virtually anything, but having a particular amount and due date helps you visualize your goals better, specifically what you are saving for. 

It is a budgeting strategy that you may use until you attain your objective. Some typical reasons why people want to set up such a fund include

  • Purchases or financing of vehicles

  • Car maintenance or repairs

  • Home renovation or remodeling

  • Premiums for insurance

  • Purchasing new furnishings

  • Vacation savings

  • Travel and holiday presents

  • Self-employment taxation

  • A major occasion, such as a birthday, wedding, or baby shower

  • Living expenses when on parental leave, such as maternity leave

From a corporate perspective, it is a business fund that holds money that is set aside to pay off a debt or a bond. 

The fund serves to mitigate the financial impact of a substantial expenditure of income when a firm issues debt. In the years running up to the maturity of the bond, a corporation will contribute to this fund.

It also enables a corporation that has issued debt in the form of bonds to save money gradually in order to avoid a hefty lump sum at the end of the bonds' maturity. 

Some bonds may be issued with a provision such as sinking funds attached to them in order to give lenders more confidence in the bond's repayment. The dates on which the issuer can redeem the bond early will be listed in the prospectus for this form of bond. 

While the cash reserved in this type of fund ensures that firms have adequate cash set aside to pay down their debt, it may also be used to repurchase preferred shares or outstanding bonds in specific instances.

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objectives

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1. Lower default risk: 

For investors, a sinking attachment offers a layer of security to a corporate bond offering. There is less of a chance for default on the money possessed at maturity because funds have been put aside for that reason. 

In other words, if it is formed, the amount owed upon maturity is significantly reduced.

As a result, it protects investors in the event of a company's insolvency or default by ensuring that investors are reimbursed. It can also help a corporation alleviate fears of default, which can attract additional investors to purchase their bond issue.

2. Creditworthiness: 

As previously stated, the sinking attachment serves to reduce the risk of default. As a result, interest rates on bonds with this type of fund attached are often lower. 

Firms issuing these bonds are considered creditworthy, which can assist investors and rating agencies in giving these bonds a higher credit rating. This is particularly useful if a corporation has to issue further debt or bonds in the future. 

Multiple repurchases are also encouraged due to the excellent credit rating.

3. Financial Impact: 

Lower interest rates might assist in improving a company's cash flow. This is due to the fact that lower interest rates mean cheaper debt-servicing costs. Over time, an increase in cash flow might lead to profitability.

Investors may be more willing to invest in the company's bonds if it is believed to be profitable. Bond prices may rise as demand rises, allowing the corporation to acquire extra money if necessary.

The pros and cons of sinking funds 

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Advantages & Disadvantages of Corporate Use
Advantages for corporate useDisadvantages for corporate use
  • It assists businesses in gathering the necessary finances for loan repayment on maturity, as paying a large quantity of money all at once is difficult.
  • Bonds are purchased before maturity using a sinking fund, and the holder loses interest income for the remainder of the time.
  • Bonds backed by a sinking prospectus have a lower risk than other bonds since they are secured by collateral.
  • Since companies utilized the fund to purchase back bonds from the market when the market was low (i.e., when bonds were selling at a discount or par value), which may have resulted in a loss for investors.
  • It provides security to investors who invest in the firm's bonds by ensuring that the issuing company will not default on payments if the fund is used for debt repayment.
  • When a corporation receives adequate money, it benefits the company rather than the investors, who may lose interest in that investment due to uncertainty.
  • It helps to attract additional investors and gain their trust by increasing the company's goodwill by paying its bills on time.

    Advantages & Disadvantages of Personal Use

    Advantages for personal useDisadvantages for personal use
    • Saving for unforeseen expenditures like yearly life insurance premiums, vehicle insurance premiums, sewage bills, automobile repairs, and so on
    • Money may be spent elsewhere. For example, you may be saving money for a vacation, but then you see a flat-screen TV on sale and decide to spend your vacation savings on this instead.
    • Putting money aside for significant purchases or creating an emergency reserve
    • Not being strict enough - The investor must be disciplined enough to see the process through.
    • Avoid incurring debt
    • Giving up on little gains, such as not seeing your cash increase as rapidly as you'd want.
    • Earn interest on savings
    • Spreading yourself too thin when you don't have much money to save at the end of the month.
    • Avoid making spontaneous purchases
    • It becomes more challenging if you are attempting to fund many accounts

    Callable bonds

    When a firm issues callable bonds, it indicates that the company can use a sinking fund to retire or pay off a portion of the bonds early.

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    A call option is built into these bonds, providing the issuer the ability to 'call' or buy back the bonds. 

    A callable bond specifies when the bonds can be called, the price levels at which they can be called, and the number of bonds that can be called. However, only a small percentage of bonds are callable, and the callable bonds are generally picked at random using their serial numbers.

    A callable bond is often called for an amount somewhat over par value, with the call value of those called sooner being greater.

    For example, if a bond is callable at $103, the business will pay the investor $1030 for each $1000 in face value, even if the price drops to 102 after a year due to restrictions.

    The corporation can issue fresh debt at a lower interest rate than the callable bond if the interest rate falls after the bond is issued. The proceeds from the second issue will subsequently be used to pay off the callable bonds by exercising the call feature.

    Consequently, the corporation has been able to refinance its debt by paying off the higher-yielding callable bonds with newly-issued debt at a reduced interest rate, resulting in an internal financing scheme.

    When interest rates fall, bond prices rise because the face value of the bonds is less than the current market price. In this situation, the bonds might be called by the corporation, which redeems the bonds at face value from investors. 

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    As a result, the investors would lose part of their interest payments, resulting in lower long-term income.

    Because sinking fund prices are frequently lower than call prices in bond debentures, an investor's bond is less likely to be repurchased under this provision compared to a call provision. This is due to the fact that bond indentures are often less expensive than call indentures. 

    As a result, holders of bonds with a sinking attachment risk losing even more money if the buyback occurs.

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    Examples of sinking bond funds

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    1. A numerical example 

    Consider the case of ABC, which has a $1.5 million debt with a 6% interest rate and a 5-year payback period. The ABC corporation intends to establish a sinking fund of $50,000 at the end of five years, with a 4% interest rate. 

    The corporation must now decide the recurring annual payments that will be used to create the fund and contribute to it.

    The sinking bond fund formula is: A / (((1 + r / n)(t*n)-1) / (r / n))

    The periodic amount would be determined as follows: 

    - $50,000 = A* (1+0.04) ^ 5 -1 /0.04 

    - $50,000 = A* (1+0.4) ^ 5 -1 /0.04

    - $50,000 = A* (1.2167 -1 )/ 0.04

    - $50,000 = A* (0.2167)/0.04 = 

    - $50,000 = A* 5.4163

    A = $50,000/5.4163 = 9,231.39

    As a result, the corporation will need to put aside $9,231.39 in the fund, which will be used to pay off debts early.

    2. Callable bonds example

    Assume ABC intends to issue $40 million in callable bonds with an interest rate of 8% for a 10-year term. The interest rate has been reduced by 2%, resulting in an updated interest rate of 6%. A $6 million sinking fund bond is also held by the corporation.

    ABC has two options: 

    • ABC might reissue the bonds at a reduced rate of interest by calling them back. 

    • ABC may also choose to repay the call premium associated with the callable bonds with sinking fund bonds.

    3. Practical application example 

    Suppose ABC has a $15 million debt that must be paid off in ten years at a 5% interest rate. A downturn in the economy also puts the corporation in danger of default. Interest rate risk has also increased as a result of this.

    Now, in order to deal with such a circumstance and mitigate this risk, ABC proposes to create a sinking fund bond, into which it will invest $1 million yearly for the next three years.

    The corporation would have three million at the completion of the three years to pay off the remaining debt due at the end of the term.

    6 reasons to start a sinking fund now: 

    6 Reasons

    1. Avoiding interest charges 

    The biggest justification for setting up this type of fund is that it allows you to avoid taking out a loan and paying interest. Interest costs can range in size from a small amount to a considerable sum, depending on the interest rate and payback duration. 

    Some of the top savings accounts provide up to a 2% annual percentage yield (APY), but what if your loan interest rate is greater than the interest received from your savings account?

    For example, if you have a good credit rating, the personal loan interest rates will start at 6%. This is already higher than the top savings APY. Furthermore, if your credit rating is bad, your APR may easily be more than 20%, which is a large amount to pay debt interest.  

    This means that your discretionary income is reduced by the monthly interest cost. That means you'll have less money to put aside for unexpected bills, to invest, or save.

    2. You don't have to worry about your emergency fund.

    When individuals don't have a reserve fund, they tend to dip into their emergency funds if money is needed quickly. After taking out the money, the individual will have to replenish the emergency fund while continuing to meet regular monthly obligations.

    This means that when emergencies occur, such as medical emergencies or unanticipated house repairs, there will not be enough funds in the account set aside for these unforeseen needs. 

    Although expensive, known prospective costs can be avoided as it's much easier to replenish your emergency fund when you have a substantial amount in the sinking fund.

    Additionally, It might take a long time to rebuild your emergency fund if you have a low income or high monthly costs. 

    3. You can pay off debt at the same time.

    Perhaps you're currently paying off a debt on a monthly basis. You'll need to make smaller extra monthly payments if you divert a portion of your extra cash to your sinking fund.

    On the bright side, you can still make extra debt payments while building up your savings. To appropriately finance your new savings goal, you may need to change your monthly budget. 

    The easiest strategy to cut your monthly expenses is to reduce your spending by canceling or renegotiating pricey subscriptions.

    At times, optimizing your spending habits might be a delicate balancing act. It's satisfying to be able to set aside money each month to save for the future.

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    4. Avoid impulse purchases

    Having a reserve fund might also help you avoid making costly impulse purchases that will take years to pay off.

    When shopping for a replacement car, for example, you may be quite inclined to buy one after just one test drive. Later on, the sensation of the buyer's regret sets in. This typically happens when you're making your first monthly payment on the car.

    Limiting your purchase price to your sinking fund's current level might help you avoid impulsive purchases.

    5. You earn a variable income. 

    When you have a fluctuating income, you must be resourceful in order to save money. 

    It is true that it can be difficult to foresee your monthly or annual wages, but you can still try and estimate your monthly and forthcoming costs. 

    These can include utility bills, rent, etc. This way, you can invest in it during the good months, such as when there are fewer bills to pay or when you receive a bonus. This might help you avoid financial hardship during the bad months.

    If you are a freelancer or part-time worker with great fluctuations in income, you may just have to focus on paying your monthly bills if you are proactive about saving for particular needs.

    6. We don't know what will happen in the future.

    Another reason to begin saving now is that none of us can anticipate what will happen in the future. For example, knowing the exact purchase price of the item you want, loan interest rates, or even your monthly income and spending pattern can be difficult to predict. 

    Therefore, it can help you plan for the unexpected by making regular monthly payments. After all, if you save on a monthly basis for retirement or have a pension fund and other long-term expenses, why not do the same for your immediate needs?

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    It can help individuals prepare for unforeseen or unexpected events, whether a medical bill, vacation plans, or house repair items. 

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    It can also help to alleviate financial burdens when there is a large fluctuation in income because the funds stored in the account can be used for different purposes. This makes financial budgeting a lot easier and helps individuals visualize their goals more clearly. 

    On the corporate side, this fund is used for repurchasing bonds or callable bonds. There are numerous benefits of attaching it to bonds, such as an increase in creditworthiness, reduced risk, and security for investors.

    Alternatively, it is used to 'call back' bonds before the maturity date, which can refinance their debt. 

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    Researched and authored by Freida LeeLinkedIn 

    Edited by Colt DiGiovanni | LinkedIn

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