Maturity date refers to the final payment date of a loan or other financial instrument. A callable bond allows the issuer to redeem the bond before the maturity date; this is likely to happen when interest rates go down. A sinking fund is a method by which an organization sets aside money to retire debts. Other important features of bonds include the yield, market price, and putability of a bond. In these situations, the investor pays less for the bond, say $950 for a $1,000 bond.

• The Bank of Montreal issued a $10,000,000 face value bond carrying a 5.1% coupon with 30 years until maturity.
• The provision will then allow him to buy back the bonds at a lower price if the market price is lower or at face value if the market price goes higher.
• A lot of people are aware of what a sinking fund is because even school children understand that it is an important and effective way of saving money for something that they want to buy or own.
• After 10 years, the Bank of Montreal will accumulate $2,001,722.10 in its sinking fund.
• A bond sinking fund is a corporation’s noncurrent asset that is restricted for the purpose of redeeming or buying back its bonds payable.

Creditors, investors, and companies benefit from the creation of a sinking fund. By taking a disciplined approach and directing money to these funds, the likelihood of default on the corresponding bonds is lowered. Companies are oftentimes rewarded for lowering this risk, since investors will be willing to accept a lower rate of interest because of this fund. The sinking fund is shown under the investment section on the balance sheet of the issuing corporation. The accounting procedure regarding interest expense recognition and other aspects of bonds is not affected by the existence of a bond sinking fund.

Benefits of a Sinking Fund

For example, a bond callable at a price of 102 pays the investor $1,020 for each $1,000 in face value, yet stipulations might state that the price goes down to 101 after a year. Adjust for the “missing pennies” (noted in red) and total the bond payment amount, interest at yield rate, and discounts accrued. Adjust for the “missing pennies” (noted in red) and total the bond payment amount, interest at yield rate, and amortized premiums. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. The number of periodic payments to the fund is based on the expected return that the trustee can earn on the assets in the fund.

• Another example may be a company issuing $1 million of bonds that are to mature in 10 years.
• To lessen its risk of being short on cash ten years from now, the company may create a sinking fund, which is a pool of money set aside for repurchasing a portion of the existing bonds every year.
• Though most bonds take several years to mature, it is always easier and more convenient to be able to reduce the principal amount long before it matures, consequently lowering credit risk.
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• 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.

Let’s say for example that ExxonMobil Corp. (XOM) issued $20 billion in long-term debt in the form of bonds. The company established a sinking fund whereby $4 billion must be paid to the fund each year to be used to pay down debt. By year three, ExxonMobil had paid off $12 billion of the $20 billion in long-term debt. If interest rates decline after the bond’s issue, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature.

However, investors may have concerns over the bonds being redeemed before maturity, as they will lose out on interest income. Potential investors are requiring that ABC establish a bond sinking fund into which ABC will make annual deposits of $500,000. An independent trustee will invest the corporation’s annual deposits with the goal of the sinking fund balance growing to approximately $20 million by the time the bonds come due in 20 years. By purchasing the bond at a discounted price of $9,475.79 and holding it until maturity, when it has a redemption price of $10,000, Baseline Industries earns a $524.21 capital gain.

In our example above, let’s say by year three, the company needed to issue another bond for additional capital. Since only $8 billion of the $20 billion in original debt remains, it would likely be able to borrow more capital since the company has had such a solid track record of paying off its debt early. 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.

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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. A bond sinking fund is similar to restricted cash in the sense that the company must put aside to buy back bonds that the company had issued. A separate trustee would hold the cash for the company, which is why it is labeled as restricted cash.

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bond sinking fund definition

The corporation saves $120,000 in interest payments in the first year and additional money thereafter. It is listed as an asset on a balance sheet but it is not used as a source of working capital so cannot be considered a current asset. The prospectus of the bond issue can provide details of the callable feature including the timing in which the bonds can be called, specific price levels, as well as the number of bonds that are callable. Typically, only a portion of the bonds issued are callable, and the callable bonds are chosen at random using their serial numbers.

What does sinking fund do?

A company that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship of a large outlay of revenue. A sinking fund is established so the company can contribute to the fund in the years leading up to the bond’s maturity. By purchasing the bond at a premium price of $10,560.14 and holding it until maturity, when it has a redemption price of $10,000, Baseline Industries takes a $560.14 capital loss. It receives $1,800 in bond payments, loses $560.14, and realizes nominal net income of $1,239.86.

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments. If they are cumulative (e.g. if in year 2 the issuer can call 2 million if a million was not called the year before) then you’re best left off with a monte-carlo simulation. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. In addition, the issuers are paying off their loans and the interest on them in installments, gradually reducing the sum due at the end of the term.

Retirement of Bonds and Sinking Fund

It is also one way of enticing investors because the fund helps convince them that the issuer will not default on their payments. 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.