What is a Debt Service Fund?

A debt service fund is a cash reserve that is used to pay for the interest and principal payments on certain types of debt. It is routinely employed by state and local governments to ensure that there is sufficient cash to service their debt obligations. The main characteristics of a debt service fund are as follows:

Financial reports required. Governments must report debt service funds in their financial statements, often as part of their fiduciary responsibility and to provide transparency in the use and allocation of taxpayer dollars.
Legally required. Many governments are legally required to maintain debt service funds to comply with bond covenants and other regulatory requirements, providing creditors assurance of repayment.
Restricted purpose. The primary function of a debt service fund is to collect resources earmarked for paying off principal and interest on long-term debt. Funds in this account are strictly for debt service payments.
Separately managed. Debt service funds are managed separately from other funds to ensure transparency and clarity regarding resources dedicated to debt repayment, helping stakeholders clearly see the amounts set aside and used for debt obligations.
Specific funding sources. Revenue for debt service funds often comes from dedicated sources like taxes (e.g., property taxes) or specific revenue streams that are pledged to debt repayment, ensuring a steady flow of resources for meeting debt obligations.

Advantages of a Debt Service Fund

The existence of a debt service fund is intended to reduce the risk of a debt security for investors, since it ensures that funds are being set aside to meet the borrower’s debt obligations. It also enhances the accountability of the borrower, which is being forced to set aside a portion of its earnings to make the designated debt payments. Because of this accountability, it makes the debt offering more attractive to investors, which may reduce the effective interest rate needed to sell the offering.

Disadvantages of a Debt Service Fund

A clear disadvantage of a debt service fund is that it ties up a portion of the cash that the debt issuer receives from the debt offering, so that it cannot be applied to more useful investments. This reduces the usefulness of the debt issuance to the borrower.