Reviewed by Oct 05, 2020| Updated on
A sinking fund is a fund that includes funds set aside or borrowed to pay off a loan or debt. A business that issues debt will have to pay off the debt in the future, and the sinking fund helps ease the burden of a significant revenue outlay.
A sinking fund is formed so that in the years leading up to the maturity of the bond, the corporation will contribute to the fund. A sinking fund allows businesses that have floated debt in the form of bonds to slowly save money and prevent a large lump-sum payment at maturity. Some bonds are issued with a sinking fund feature attached to them.
A sinking fund provides an element of protection for investors in a corporate bond issue. Because funds are set aside to pay off the bonds at maturity, the risk of default on the money owed at maturity is lower. In other words, when a sinking fund has formed the sum owed at maturity is significantly less.
As a result, a sinking fund can help creditors get some insurance in case of bankruptcy or default on the company. A sinking fund also helps a company to decrease default risk concerns, and thus attract more investors to issue their bonds.
Since a sinking fund adds a security factor and lowers default risk, interest rates on the bonds are usually lower. As a result, the company is commonly viewed as creditworthy, which can contribute to higher debt credit scores.
Good credit ratings increase investor demand for a company's bonds, which is particularly helpful in future when a company needs to issue additional debt or obligations.