Sinking Fund
Quick Definition
A provision requiring the bond issuer to set aside money periodically to retire a portion of the debt before maturity.
Key Takeaways
- Requires periodic retirement of a portion of outstanding bonds
- Issuer can buy in the open market or call by lottery at par
- Reduces credit risk by preventing large balloon payments
- May create reinvestment risk if bonds are called at par above market
What Is Sinking Fund?
A sinking fund is a bond indenture provision that requires the issuer to retire a specified portion of the outstanding bonds at regular intervals, typically annually, before the final maturity date. The issuer can satisfy the sinking fund requirement by either purchasing bonds in the open market (if trading below par) or calling bonds at par via a lottery. Sinking funds reduce credit risk for bondholders by ensuring the issuer does not face a large "balloon" payment at maturity, gradually reducing the outstanding debt burden. However, they also introduce reinvestment risk — particularly the lottery call feature, which may force investors to give up bonds at par when market prices are higher. Sinking funds are most common in corporate bonds.
Sinking Fund Example
- 1A $500 million bond issue with a sinking fund might require the company to retire $50 million annually starting in year 5
- 2If a bond trades at 105 ($1,050), the issuer would buy bonds in the open market rather than calling at par ($1,000) — but if it trades at 95, they'd call at par
Related Terms
Bond Indenture
The legal contract between a bond issuer and bondholders that specifies the bond's terms, covenants, and the rights and obligations of each party.
Callable Bond
A bond that gives the issuer the right to redeem it before maturity at a specified price, typically when interest rates fall.
Amortizing Bond
A bond that repays both principal and interest over its life through regular payments, rather than returning all principal at maturity.
Reinvestment Risk
The risk that cash flows from a bond (coupons or principal) will be reinvested at lower interest rates than the original investment.
Bond
A fixed-income debt security where investors loan money to an issuer in exchange for regular interest payments and return of principal at maturity.
Treasury Bond (T-Bond)
A long-term U.S. government debt security with a maturity of 20 or 30 years, paying semiannual coupon interest.
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