sinking fund
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A sinking fund is a fund established by an
economic entity In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compa ...
by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
. In North America and elsewhere where it is common for public and private corporations to raise funds through the issue of bonds, the term is normally used in this context. However, in the United Kingdom and elsewhere where the issue of bonds (other than government bonds) is unusual, and where long-term leasehold tenancies are common, the term is only normally used in the context of replacement or renewal of capital assets, particularly the common parts of buildings. Borrowing money by issuing a bond is referred to as floating a bond. Sinking is its opposite, repaying debt or acquiring capital assets without debt.


Historical context

The sinking fund was first used in
Great Britain Great Britain is an island An island (or isle) is an isolated piece of habitat that is surrounded by a dramatically different habitat, such as water. Very small islands such as emergent land features on atoll An atoll (), ...

Great Britain
in the 18th century to reduce
national debt In public finance, government debt, also known as public interest, public debt, national debt and sovereign debt, is the total amount of debt owed at a point in time by a government A government is the system or group of people govern ...
. While used by
Robert Walpole Robert Walpole, 1st Earl of Orford, (26 August 1676 – 18 March 1745; known between 1725 and 1742 as Sir Robert Walpole) was a British British may refer to: Peoples, culture, and language * British people, nationals or natives of the Unit ...

Robert Walpole
in 1716 and effectively in the 1720s and early 1730s, it originated in the commercial tax syndicates of the Italian peninsula of the 14th century, where its function was to retire redeemable public debt of those cities. The fund received whatever surplus occurred in the national Budget each year. However, the problem was that the fund was rarely given any priority in Government strategy. The result of this was that the funds were often raided by the Treasury when they needed funds quickly. In 1772, the nonconformist minister
Richard Price Richard Price (23 February 1723 – 19 April 1791) was a Welsh moral philosopher, Nonconformist minister and mathematician. He was also a political reformer, pamphleteer, active in radical, republican, and liberal causes such as the French a ...

Richard Price
published a pamphlet on methods of reducing the national debt. The pamphlet caught the interest of
William Pitt the Younger William Pitt the Younger (28 May 175923 January 1806) was a prominent Tory A Tory () is a person who holds a political philosophy Political philosophy or political theory is the philosophical Philosophy (from , ) is the st ...

William Pitt the Younger
, who drafted a proposal to reform the ''Sinking Fund'' in 1786.
Lord North Frederick North, 2nd Earl of Guilford (13 April 17325 August 1792), better known by his courtesy title Courtesy (from the word ''courteis'', from the 12th century) is gentle politeness and courtly manners. In the Middle Ages I ...

Lord North
recommended "the Creation of a Fund, to be appropriated, and invariably applied, under proper Direction, in the gradual Diminution of the Debt". Pitt's way of securing "proper Direction" was to introduce legislation that prevented ministers from raiding the fund in crises. He also increased taxes to ensure that a £1 million surplus could be used to reduce the national debt. The legislation also placed administration of the fund in the hands of " Commissioners for the Reduction of the National Debt". The scheme worked well between 1786 and 1793 with the Commissioners receiving £8 million and reinvesting it to reduce the debt by more than £10 million. However, the outbreak of war with France in 1793 "destroyed the rationale of the Sinking Fund" ( Eric Evans). The fund was abandoned by
Lord Liverpool Robert Banks Jenkinson, 2nd Earl of Liverpool, (7 June 1770 – 4 December 1828) was a British Tory The Tories were a political faction Politics (from , ) is the set of activities that are associated with making decisions in gro ...

Lord Liverpool
's government only in the 1820s. Sinking funds were also seen commonly in investment in the 19th century in the United States, especially with highly invested markets like railroads. An example would be the Central Pacific Railroad Company, which challenged the constitutionality of mandatory sinking funds for companies in the case ''In re Sinking Funds Cases'' in 1878.


Modern context – bond repayment

In modern finance, a sinking fund is, generally, a method by which an organization sets aside money over time to retire its indebtedness. More specifically, it is a fund into which money can be deposited, so that over time
preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital __NOTOC__ A corporation's share capital
,
debenture In corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and ...
s or stocks can be retired. See also "sinking fund provision" under Bond (finance)#Features. In some US states,
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Michigan
for example, school districts may ask the voters to approve a taxation for the purpose of establishing a sinking fund. The State Treasury Department has strict guidelines for expenditure of fund dollars with the penalty for misuse being an eternal ban on ever seeking the tax levy again.


Types

A sinking fund may operate in one or more of the following ways: # The firm may repurchase a fraction of the outstanding bonds in the open market each year. # The firm may repurchase a fraction of outstanding bonds at a special call price associated with the sinking fund provision (they are
callable bondA callable bond (also called redeemable bond) is a type of bond Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financ ...
s). # The firm has the option to repurchase the bonds at either the market price or the sinking fund price, whichever is lower. To allocate the burden of the sinking fund call fairly among bondholders, the bonds chosen for the call are selected at random based on serial number. The firm can only repurchase a limited fraction of the bond issue at the sinking fund price. At best some indentures allow firms to use a ''doubling option'', which allows repurchase of double the required number of bonds at the sinking fund price. # A less common provision is to call for periodic payments to a trustee, with the payments invested so that the accumulated sum can be used for retirement of the entire issue at maturity: instead of the debt amortizing over the life, the debt remains outstanding and a matching asset
accrueAccrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabili ...
s. In this way a fund is built up with the intention of paying off the debt in full at a specified future date instead of directly paying the debt down over time. This method was popular in the 1980s-90's in the UK household
mortgage A mortgage loan or simply mortgage () is a loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient (i.e., the borrower) incurs a ...
market.


Benefits and drawbacks

For the organization retiring debt, it has the benefit that the principal of the debt or at least part of it, will be available when due. For the creditors, the fund reduces the risk the organization will default when the principal is due: it reduces
credit risk A credit risk is risk of default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they ope ...
. However, if the bonds are callable, this comes at a cost to creditors, because the organization has an
option Option or Options may refer to: Computing *Option key, a key on Apple computer keyboards *Option type, a polymorphic data type in programming languages *Command-line option, an optional parameter to a command *OPTIONS, an Hypertext Transfer Prot ...
on the bonds: * The firm will choose to buy back discount bonds (selling below par) at their market price, * while exercising its option to buy back premium bonds (selling above par) at par. Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at below-market prices. In this case, the firm's gain is the bondholder's loss – thus callable bonds will typically be issued at a higher coupon rate, reflecting the value of the option.


Modern context – capital expenditure

Sinking funds can also be used to set aside money for purposes of replacing capital equipment as it becomes obsolete, or major maintenance or renewal of elements of a fixed asset, typically a building. Such a fund is also commonly called a reserve fund, however the distinguishing feature of a sinking fund is that the payments into it are calculated to amortize a forecast future expenditure whereas a reserve fund is intended to equalise expenditure in respect of regularly recurring service items to avoid fluctuations in the amount of service charge payable each year.


External links


Online annual sinking fund calculator


References

* Bodie, Kane and Marcus. 2007. Essentials of Investments. Sixth International Edition. Singapore: McGraw Hill. {{DEFAULTSORT:Sinking Fund Bonds (finance) Public finance Corporate finance