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Answer:
Dear
J. Reilly,
No
need to get a sinking feeling. A sinking fund is not
the same thing as a sinking ship.
Definition
Technically
speaking, a sinking fund is a separate reserve account
held in a trust. It is funded on a regular basis by
a corporation (or municipality) that has issued bonds
or preferred stock and is required to do so by the
terms of its charter. In other words, the issuer must
make periodic payments to the sinking fund. It is
not an option.
Money
in the trust or sinking fund, which is similar to
a custodial account, is then used by the corporation
or municipality to redeem their debt securities (bonds)
or preferred stock in the open market at the current
price.
The
purpose of a sinking fund is to ensure that the entire
issue is retired (or taken out of circulation) in
an orderly fashion before the stated maturity date.
A
theoretical example
Let's
say that a company issues $20 million in bonds with
a 20-year maturity. If its charter so requires, it
will then buy back a stated amount -- perhaps $1 million
worth -- of bonds at par every year.
Related
terms
You
may encounter other similar sounding Wall Street jargon.
A sinker, for instance, is a bond issue for
which the issuer must establish a sinking fund.
A
sinking fund provision is a written statement
stipulating that the borrower (that is, the issuer)
retire a certain portion of the debt on an annual
basis.
Retiring
the debt
The
retirement of the debt can be done in one of two ways
-- by calling the bonds from investors (if interest
rates have declined) or by purchasing the bonds in
the open market (if interest rates have increased).
The
Bottom Line
A
sinking fund actually gives the bondholder an extra
layer of protection against default. And, it ensures
an orderly retirement.
Most
experts believe that bonds or preferred stocks with
a sinking fund are safer than those for which the
issuer must make payment all at once, without the
benefit of an already existing source of money.
The
only disadvantage you should be aware of is that the
requirement to retire a certain number of bonds may
mean that bondholders have to give up a high-yielding
bond at par during a time period when interest rates
are declining.
Good
luck!
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