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.

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.