Definition: A sinking fund bond is a bond that requires the issuer to set aside a specific amount of assets on certain dates to repay bondholders. In other words, it’s a bond that requires the issuing entity to create a sinking fund to be used as collateral in case the issuer can’t pay the bondholders in the future.
What Does Sinking Fund Bond Mean?
Sinking fund bonds are often used by companies that have less than desirable credit ratings. The credit ratings aren’t poor, but investing money in one of their bonds is risky. Investors need extra incentives to protect them from the risk of default and assure them that the issuer will be able to repay the bond principle once it matures.
You can think of the sinking fund like collateral. 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. For example, an agreement might require 50 percent of the assets be placed in the fund on the issue date, 25 percent be placed in mid-term, and the remaining assets be placed in the fund on the maturity date.
The sinking fund helps mitigate the risk associated with purchasing one of these bonds. Bondholders know that a pool of assets is available in case the issuer defaults on its contract. This is the same concept behind posting your house as collateral for a mortgage. The bank knows that if you are unable to make your payments, they will be able to recoup the debt by selling the house.
In this way, bondholders decrease their risk and issuers are more likely to attract investors at less expensive rates. Again, this is typically only used for issuers with less than perfect credit ratings where investors need more confidence to invest.