Fund set aside by a corporation or government agency for the purpose of periodically redeeming bonds, debentures, and preferred stocks. The fund is accumulated from earnings, and payments into the fund may be based on either a fixed percentage of the outstanding debt or a fixed percentage of profits. Sinking funds are administered separately from the corporation's working funds by a trust company or trustee. The purpose of a sinking fund is to assure investors that provision has been made for the repayment of bonds at maturity.
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A Sinking Fund was a device used in Great Britain in the 18th century to reduce national debt. While used by Robert Walpole in 1716 and effectively in the 1720s and early 1730s, it originated in the commercial tax syndicates of the Italian peninsula of the 14th century to retire redeemable public debt of those cities.
The fund received whatever surplus occurred in the national Budget each year. However, the problem was that the fund was rarely given any priority in Government strategy. The result of this was that the fund was often raided by the Treasury when they needed funds quickly.
In 1772, the nonconformist minister Richard Price published a pamphlet on methods of reducing the national debt. The pamphlet caught the interest of William Pitt the Younger, who drafted a proposal to reform the Sinking Fund in 1786. Lord North recommended "the Creation of a Fund, to be appropriated, and invariably applied, under proper Direction, in the gradual Diminution of the Debt." Pitt's way of securing "proper Direction" was to introduce legislation that prevented ministers from raiding the fund in crises. He also increased taxes to ensure that a £1 million surplus could be used to reduce the national debt. The legislation also placed administration of the fund in the hands of "Commissioners for Reducing the National Debt."
The scheme worked well between 1786 and 1793 with the Commissioners receiving £8 million and reinvesting it to reduce the debt by more than £10 million. However, the advent of war with France in 1793 "destroyed the rationale of the Sinking Fund" (Evans). The fund was abandoned by Lord Liverpool's government only in the 1820s.
Sinking funds were also seen commonly in investment in the 1800s in the United States, especially with highly-invested markets like railroads. An example would be the Central Pacific Railroad Company, which challenged the constitutionality of mandatory sinking funds for companies in the case, In Re Sinking Funds Cases in 1878.
In some US states, Michigan for example, school districts may ask the voters to approve a taxation for the purpose of establishing a Sinking Fund. The State Treasury Department has strict guidelines for expenditure of fund dollars with the penalty for misuse being an eternal ban on ever seeking the tax levy again. See also sinking fund provision in bonds.
Thus in both cases, the total debt outstanding decreases over the life of the bonds, but in one case, it happens across all bonds, while in the other, some bonds are repaid and others are not.
Note also that sinking funds may be more discretionary – if a bond issuer fails to make a principal payment on an amortizing bond, they are in default, while a sinking fund may choose to not repurchase bonds, thus giving more flexibility.
However, if the bonds are callable, this comes at a cost to creditors, because the organization has an option on the bonds:
Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at below-market prices. In this case, the firm's gain is the bondholder's loss – thus callable bonds will typically be issued at a lower coupon, reflecting the value of the option.
Indiana Court of Appeals rules against building authority on sinking fund. (Evansville-Vanderburgh County Building Authority)
Jan 25, 1994; CHICAGO -- The Indiana Court of Appeals has ruled against a building authority accused of investing sinking fund money for its...