Sinking fund
Also known as: sinking fund provision
A sinking fund is a pool of money an issuer sets aside on a regular schedule to retire a bond issue before or at maturity. It reduces the risk that the issuer will be unable to repay principal when the debt comes due.
A sinking fund provision requires a bond issuer to deposit money into a segregated account at set intervals over the life of the issue. The trustee uses those deposits to retire bonds gradually — by calling them at a stated price, buying them in the open market, or simply accumulating cash to pay off the remaining principal at maturity. Instead of facing one large balloon repayment, the issuer chips away at the obligation year by year.
The mechanics matter to bondholders in two ways. Credit quality improves, because a funded repayment plan makes default less likely; rating agencies treat a sinking fund as a positive covenant, and bonds carrying one generally sell at lower yields than otherwise identical bonds without one. At the same time, individual holders face call risk — if the trustee retires bonds by lottery, a specific investor's bonds may be redeemed years early, often when rates have fallen and reinvestment would be unattractive.
In engineering economics and managerial accounting, "sinking fund" describes the same idea as a time-value-of-money calculation: the sinking fund factor converts a future lump sum into the equal periodic deposits needed to accumulate it, given an assumed interest rate. Companies use the concept to plan for equipment replacement, asset retirement obligations, and scheduled debt repayment.
On the Series 7 exam, sinking funds appear in revenue bond analysis — a strong sinking fund is one of the protective covenants that makes a revenue bond safer. The FE Civil exam tests the sinking fund factor as part of engineering economics, and the CIMA Certificate in Business Accounting covers the same discounting mechanics under the time value of money.
Key takeaways
- A sinking fund is money set aside on a schedule to retire a bond issue over time rather than all at once.
- It strengthens the issuer's credit profile, so sinking fund bonds typically carry lower yields than comparable bonds without one.
- Bondholders take on call risk, since bonds may be redeemed early by lottery or open-market purchase.
- In engineering economics, the sinking fund factor converts a future target amount into the required equal periodic deposits.