A bond sinking fund is an escrow account into which a company places cash that it will eventually use to retire a bond liability that it had previously issued. The existence of this fund provides some security to bond holders, since it improves the likelihood that the issuer will eventually retire the associated bonds. The escrow account is administered by an independent trustee, which is also responsible for investing the funds within a specific set of predetermined investment criteria, as well as for redeeming bonds under the terms of the bond agreement.
There are several ways in which a sinking fund can be used to repurchase bonds:
- Repurchase bonds periodically on the open market
- Repurchase bonds periodically at a specific call price
- Repurchase bonds periodically at the lower of the market price or a specific call price
- Repurchase only at the maturity date of the bonds
The existence of a bond sinking fund, as well as the amount of funds to be placed in it, is usually governed by the terms of the bond agreement. A bond sinking fund reduces the risk for investors, since they can be reasonably assured that there will be at least some funds available to retire their bonds at some point in the future. Given this lower level of risk, investors may accept a lower effective interest rate from the issuer than would be the case for a bond having no associated sinking fund.
Since the presence of a bond sinking fund reduces the risk for investors, it is a particularly attractive option when the bond issuer has somewhat questionable finances, and so presents a greater risk of default.
A bond sinking fund may allow a company to buy back bonds at certain prices and intervals. If so, this can have a countervailing impact on the effective interest rate that investors are willing to pay, since there is some uncertainly about whether their bonds will be retired early, and at what price.
The bond sinking fund is categorized as a long-term asset within the Investments classification on the balance sheet, since it is to be used to retire a liability that is also classified as long term. It should not be classified as a current asset, since doing so would skew a company's current ratio to make it look far more capable of paying off current liabilities than is really the case. Also, a bond sinking fund introduces a potentially large amount of cash to the balance sheet, which can be misconstrued by investors as being available for other uses; hence the need to clearly identify the use of its funds specifically to retire bonds.
When a company agrees to set up a bond sinking fund, this implies that it originally raised cash for a specific purpose that has a termination date, and so does not intend to roll forward the debt with a replacement bond issuance. The implication is that company management is using its funds in a conservative manner, rather than pushing a liability further into the future. This action also implies that the company may not find it necessary to issue bonds again in the future.