Bond sinking fund definition
/What is a Bond Sinking Fund?
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 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. The options are to repurchase them periodically on the open market, or at a specific call price, or at the lower of the market price or a specific call price, or to only repurchase at the maturity date of the bonds.
Understanding a Bond Sinking Fund
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.
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Advantages of a Bond Sinking Fund
The existence of bond sinking fund is beneficial in several ways, which include the following:
Security for bond holders. It provides some security to bond holders, since it improves the likelihood that the issuer will eventually retire the associated bonds.
Lower interest rate for issuer. Given the risk reduction for investors, they may accept a lower effective interest rate from the issuer than would be the case for a bond having no associated sinking fund.
Mitigates risk of default. It is a particularly attractive option when the bond issuer has somewhat questionable finances, and so presents a greater risk of default.
Disadvantages of a Bond Sinking Fund
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.
Classification of a Bond Sinking Fund
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.