Corporate stocks, bonds, and debentures can be a risky investment. However, there is a way for companies to minimize this risk for investors.
What is a Sinking Fund?
A sinking fund is basically a pile of money a corporation sets aside to repay its dividends on stocks or other debt instruments. Since corporations must repay the principle amount and its interest at maturity to holders, there is a chance that the final amount could be too high for a company in financial trouble. Companies that can't pay the maturity debt will default. The setting aside of assets minimizes the final bill that the company must pay when an instrument's term is up. Because the amount of debt the company has is reduced, the risk of the company defaulting is lessened.
Imagine that Ramsay's Catering Corporation (RCC) sells a bond at the principle amount of $2,500 and a lifespan of 10 years. The bonds pay out coupon payments, a.k.a. interest, every year to its investors. When the bonds reach maturity at 10 years, CTC is now faced with paying both the coupon payment and the principle investment amount to each bondholder. Theoretically, that could be a debt of $2,575 to each individual investor. If RCC hasn't performed well over the past 10 years, then the risk of default is high. However, if RCC periodically pays money to a trustee for saving, it lowers the final debt amount due at the end of the ten-year maturity. This greatly reduces the risk for RCC's bondholders.
How These Funds Work
A sinking fund is setup and administered by outside companies known as trust companies. The money within a sinking fund is accumulated from a corporation's profits. A fixed percentage, either of the debt or the profits, is used to make payments into the fund. In addition to these payments, administrators may use money from within the fund to invest in conservative bonds for asset growth. Revenue from these investments is then added to the fund. The goal of a sinking fund is to keep pace with the amount of active stock and bonds issued by the company, so as to avoid default.
In addition to being used to retire debentures and stocks, companies also use a sinking fund for purchasing various assets. For example, Businesses may establish a sinking fund that's used to replace outdated machinery. A sinking fund can also be used by school districts. Schools ask voters to approve taxation for fund establishment, and adhere to strict guidelines set forth by the State Treasury Department. Misuse of sinking funds by schools is penalized with a permanent ban on ever seeking tax levy from the state.
A Brief History of Sinking Funds
Created by Great Britain in 1717, the sinking fund is one of the various programs setup to reduce national debt. Originally, legislation was imposed that required governments to set aside surplus revenue for the repayment of capitol and interested accumulated before December 25, 1716. Unfortunately, these funds had a low priority and were often used by the Treasury for quick cash. Sinking funds appeared in the U.S. investment market in the 1800's and were commonly seen in the railroad market.
About Trust Companies
The administrator of a sinking fund, trust companies, is a corporation with the legal authority to serve as a trustee under deeds of trust and trust agreement. These companies serve individuals, businesses, governments, and non-profit institutions. They often have separate departments for individual trusts and corporate trusts. Additionally, trust companies may have or be part of commercial banks. For businesses, trust companies take title or lien on any securities and verify performance requirements.
Having a sinking fund vastly increases a company's ability to repay its debts. If you're a cautious investor, consider stocks and bonds that are backed by companies with these funds.