Bond Sinking Fund

Sinking fund is a restrictive provision included in a bond indenture to provide for the systematic retirement of a bond prior to its maturity by restricting an asset specifically for this purpose. In other words, a bond sinking fund can be defined as a restricted asset of a corporation that requires some money to be set aside for paying back some part of its bond payable.

For example, ABC company sells a bond with par value of $1,000 and a five year time span. The company would be required to pay interest payments to the owner of the bond each year. In the final year, the company would also be required to repay the principal amount of $1,000 in addition to making interest payment of $50 at the rate of 5% on the principal amount.

The company may be able to manage interest payment of $50 each year but repayment of the principal amount $1,000 may cause some cash flow problems for the company, especially if the company is in poor financial condition. In order to lessen the risk of being short of funds when the time comes to repay the principal amount of the bond, the company may create a bond sinking fund, which is a pool of funds set aside for repaying part of the bond each year. In this way the company will face a much smaller amount to be paid against the principal amount of the bond issued at the end of the five year time period.