What is a Sinking Fund?

A sinking fund is a set-aside of cash that is to be used at a later date to retire bonds or other forms of debt or preferred stock. It may also be used to fund the replacement or purchase of an asset. The sinking fund concept may also be used by an individual, who saves up money to purchase a major asset, such as a car.

Examples of a Sinking Fund

Here are three examples of how a sinking fund can be used:

Corporate bond sinking fund. A corporation issues $10 million in bonds and sets up a sinking fund to ensure it can repay the debt when it matures in 10 years. Each year, the company deposits $1 million into the fund, investing it conservatively to preserve capital. When the bonds mature, the company uses the accumulated fund to repay the bondholders without straining its cash flow.
Municipal equipment replacement fund. A city plans to replace its aging fleet of garbage trucks in five years at an estimated cost of $2 million. To prepare, it creates a sinking fund and allocates $400,000 annually from its budget into the fund. By the end of the five years, the city has enough to purchase the new trucks outright, avoiding the need for new debt.
Personal car purchase fund. An individual plans to buy a new car in three years for $30,000. They set up a sinking fund and contribute $833.33 each month into a high-yield savings account. After three years, they have enough saved to purchase the car in full, without needing to take out a loan.

Advantages of a Sinking Fund

By setting up a sinking fund, the financial burden associated with a repayment or asset purchase is greatly reduced. The existence of a sinking fund also reduces the risk for investors, who have an improved chance of being repaid when the associated debt becomes due. Also, when a sinking fund is a required part of an investing agreement, investors are more likely to allow a reduced rate of interest on the associated debt or preferred stock.

Disadvantages of a Sinking Fund

A sinking fund reduces the availability of cash for the borrower, since it is being forced to set aside cash for repayment purposes. This reduced amount of cash narrows the number of uses to which the bond proceeds can be put. In particular, a sinking fund requirement may keep an issuer from making investments that do not generate a return for an extended period of time, since it needs to start putting cash into the sinking fund relatively soon.