Wednesday, October 7, 2009
Sinking funds reduce financial pressure in a particular financial year
Sinking fund/reserves is an account where a debt issuer makes periodic deposits that will eventually be used to settle a large, long-term debt. A bond issuer, for example, might use a sinking fund to ease the repayment burden at bond maturity. The existence of the sinking fund is attractive to investors, because it lowers the risk associated with the security.
Sinking funds are used to pay for large expenses that you are planning for. You may use different sinking funds to pay for home repairs, save for a new car, pay for your vacation or to cover large medical bills. By setting the money aside before you use it, you will avoid using your emergency fund unnecessarily, as well as give yourself more negotiating power when it is time to purchase.
You can start by determining which items you want to set sinking funds up for. Then you will need to decide on how much you need in each fund. Then divide that amount by the number of months you have until you make the purchase. Finally you add these amounts into your budget.
You should keep your sinking funds in fairly liquid accounts; a high interest rate money market account would be ideal. Then you simply track how much you have in each sinking fund.
1. The corporation is protected against any loss due to unwise investment, when it is buying its own bonds, and thereby reducing its outstanding obligations. It is certainly in no danger of losing its money.
2. The rate of interest earned is the same as the yield of the market price of the bonds that are being amortized. This is an accurate statement, at least under the customary provisions that the bonds may be redeemed for the sinking fund at par or slightly above, or may be purchased in the open market at the option of the corporation, in case the market price is below the fixed redemption price. If the bonds are selling on a 6 or 7% basis, it is clear that the sinking fund will accumulate at the same rate.
3. Under the customary provisions just referred to, the market price of the bonds is maintained by the corporation’s repurchases or redemption, and in this way the credit of the corporation is supported.
4. There is nothing to prevent making a single quotation for all bonds in the issue. If a corporation buys in the open market, it takes whatever bonds happen to be for sale at the market price. If it redeems a fixed proportion of bonds each year, the bonds to be redeemed are customarily determined by lot. In this last practice there is a slight element of uncertainty which might be considered objectionable, but it is of small practical importance.
5. The burden on the corporation is equally distributed during the life of the bond issue. The simplest plan for accomplishing this result is to keep alive all the bonds purchased for the sinking fund, so that the corporation pays out the same amount of interest each year. As the number of bonds held in the sinking fund increases more and more, interest payments, it is clear, go to swell the sinking fund, and thus to increase the annual purchases or redemption's. But so far as the burden on the corporation is concerned, it remains the same year after year.
There seems to be little room for question that among all the methods of amortization, the best and simplest is the one just described of establishing a sinking fund which is used for the repurchase and redemption of all the bonds that are being amortized, and keeping alive the bonds that are taken into the sinking fund.
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