A bond sinking fund is a corporation’s noncurrent asset that is restricted for the purpose of redeeming or buying back its bonds payable. Bonds that require a bond sinking fund will mean less risk for the bondholders. Also, if interest rates decrease, which would result in higher bond prices, the face value of the bonds would be lower than current market prices. In this case, the bonds could be called by the company that redeems the bonds from investors at face value. The investors would lose some of their interest payments, resulting in less long-term income.
Commonly accepted practice allows the investor to accrue the $50 capital gain over the period of time that the bond is held and not just in the period during which the capital gain actually occurs (at maturity). For example, assuming three years remain until maturity on a $1,000 bond carrying a 5% coupon purchased when the market rate was 6.8729%,the figure illustrates the accrual of a capital gain of $50. In either situation, the gain or loss has tax implications for the investor. These amounts appear on tax forms and either raise the amount of taxes paid by the investor (for gains) or lower the amount of taxes (for losses). Par value is the amount of money a holder will get back once a bond matures; a bond can be sold at par, at a premium, or at a discount. The coupon rate is the amount of interest that the bondholder will receive per payment, expressed as a percentage of the par value.
- In the bond issue’s final year, CTC would need to pay the final round of coupon payments and also repay the entire $1,000 principal amount of each bond outstanding.
- Again, this is typically only used for issuers with less than perfect credit ratings where investors need more confidence to invest.
- A corporation’s bond sinking fund appears in the first noncurrent asset section of the corporation’s balance sheet.
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This means your company will benefit from the future bond interest payments and also realize the bond’s redemption price upon maturity. Your firm’s accounting records must show capital gains being realized over the years, in the form of the difference between the face value and the discounted amount at which the bonds were purchased. When an investor purchases a bond, they expect to receive interest payments and also get back their principal when the bond matures.
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The enhanced repayment protection offered by the sinking funds is attractive to investors seeking a safe investment. However, investors may have concerns over the bonds being redeemed before maturity, as they will lose out on interest income. The corporation will report the bond sinking fund balance in the investments section of its balance sheet.
- A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market.
- The corporation will report the bond sinking fund balance in the investments section of its balance sheet.
- As a result, a sinking fund helps investors have some protection in the event of the company’s bankruptcy or default.
- Find out the answer to these questions, and many more, with our comprehensive guide to sinking funds in accounting.
What annual sum will it deposit into the sinking fund to satisfy the provision? How does the liability side of the company’s balance sheet reflect the fund’s provisions? All these questions need to be answered so that you systemize your business can make an informed decision. A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market.
bond sinking fund definition
Since there will be funds set aside to pay off the bonds at maturity, there’s less likelihood of default on the money owed at maturity. The prospectus for a bond of this type will identify the dates that the issuer has the option to redeem the bond early using the sinking fund. While the sinking fund helps companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use the funds to repurchase preferred shares or outstanding bonds.
The issuing corporation makes periodic payments to its bond sinking fund. These monies are then invested by the trustee and eventually are used to pay the interest and principal of the bond. This is a collection of cash or other assets (e.g., marketable securities) that is set apart from the firm’s other assets and is used only for a specified purpose.
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In these situations, the investor pays less for the bond, say $950 for a $1,000 bond. If the investor holds onto the bond until maturity, the investor receives the full redemption price of $1,000. A capital gain is the amount by which the current value of an asset exceeds the original purchase price.
Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise. Ask a question about your financial situation providing as much detail as possible. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.
sinking fund definition
Since the money in the sinking fund is reserved strictly for the repayment of bonds, it cannot be used to pay for short-term liabilities. The financial accounting term bond sinking fund is used to describe cash that is set aside by a company, which is to be used to repay money owed to bondholders. A bond sinking fund is typically overseen by a trustee, who is responsible for the repurchasing of maturing bonds on the open market. Since a sinking fund adds an element of security and lowers default risk, the interest rates on the bonds are usually lower. As a result, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt. Good credit ratings increase the demand for a company’s bonds from investors, which is particularly helpful if a company needs to issue additional debt or bonds in the future.
If the bonds issued are callable, it means the company can retire or pay off a portion of the bonds early using the sinking fund when it makes financial sense. The bonds are embedded with a call option giving the issuer the right to “call” or buy back the bonds. For example, let’s say Cory’s Tequila Company (CTC) sells a bond issue with a $1,000 face value and a ten-year life span. The bonds would likely pay interest payments (called coupon payments) to their owners each year. In the bond issue’s final year, CTC would need to pay the final round of coupon payments and also repay the entire $1,000 principal amount of each bond outstanding.
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In some cases, the stock can have a call option attached to it, meaning the company has the right to repurchase the stock at a predetermined price. A sinking fund helps companies that have floated debt in the form of bonds to gradually save money and avoid a large lump-sum payment at maturity. The idea is that by consistently saving relatively small amounts of money, there will eventually be enough stored up to spend toward something more significant. The issuer is required in the bond agreement to pledge specific assets to a fund that must be available to pay off the bonds at all times. Some agreements also require that the assets be placed in the fund on specific dates.
A bond sinking fund is a fund set aside by the issuer in order to retire bonds when they mature. When investors purchase a bond, they generally look forward to receiving their interest payments in addition to the repayment of the face value of the security on its maturity date. However, if no reservation has been made to retire the bond at maturity, such as a sinking fund (or “pre-funding”), then the issuer can default on its obligation to make timely repayment. If a company utilizes a sinking fund in relation to a bond issue, the sinking fund is listed as a long-term (noncurrent) asset on the balance sheet.