 Personal Finance PowerPoint Presentation, Sinking Fund. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Sinking Fund, which you can find online. Take a look at the references, resources, continue your research from there. This by Chris B. Murphy, updated April 30th, 2021. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a Sinking Fund? A Sinking Fund is a fund containing money set aside or saved to pay off a debt or bond. A company that issues debt will need to pay that debt off in the future, and the Sinking Fund helps to soften the hardship of a large outlay of revenue. So clearly when we're talking about bonds, when we're talking about corporate bonds, on the investment side of things, we're thinking about investing in bonds, we're gonna be giving money to the issuer of the bonds, in this case, a corporation. On the corporation side of things, they're obviously wanting the capital by issuing the bonds, hopefully in order to invest in the company, generate more revenue in the future from that. When the bonds become due, there's gonna be that lump sum payment at the maturity of the bonds because as the bonds are structured, they're a little bit different than how we might structure, say, a loan or a mortgage as we have seen in prior presentations, instead of paying off the interest and principal and equal payments, typically the bonds are structured so that the company is paying out just the interest, just kind of like the rent portion of the payments, and then they got that lump sum payment that they're gonna have to plan for and deal with at the maturity of the bonds. So a Sinking Fund is established so the company can contribute to the fund in the years leading up to the bonds maturity so they have the cash flow to deal with that big lump sum outflow that could happen at the maturity of a bond. So a Sinking Fund explained, a Sinking Fund helps companies that have floated debt in the form of bonds, gradually save money and avoid a large lump sum payment at maturity. Some funds are issued with the attachment of a Sinking Fund feature. So the perspective for a bond of this type will identify the dates that the issuer has the option to redeem the bond early using the Sinking Fund. While the Sinking Fund helps companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use the funds to repurchase preferred shares or outstanding bonds. Lower default risk, a Sinking Fund adds an element of safety to a corporate bond issue for investors. So if we're an investor and we're trying to measure the different bonds that we could be purchasing or investing in from different issuers, clearly the corporate bonds are usually gonna be the ones that have the least amount of risk because you wouldn't think that the government's gonna default and not pay their debts. When we go to the corporate bonds, we might be doing some comparing and contrasting and items such as possibly a Sinking Fund could lead to more assurance that they're not gonna default on the bond which could lessen the risk on the investor side of things. So since there will be funds set aside to pay off the bonds at maturity, there's less likelihood of default on the money owed at maturity. In other words, the amount owed at maturity is substantially less if a Sinking Fund is established. As a result, a Sinking Fund helps investors have some protection in the event of the company's bankruptcy or default. A Sinking Fund also helps a company ally concerns of default risk and as a result, attract more investors for their bond issuance. Credit worthiness. Since a Sinking Fund adds an element of security and lowers default risk, the interest rates on the bonds are usually lower. As a result, the company is usually seen as credit worthy which can lead to a positive credit rating for its debt. So once again, since the Sinking Fund adds an element of security lowering default risk, that means us as the investors have less risk with the relation of the Sinking Fund that they're not gonna be paying back that particular obligation. That means the interest rates of the bonds will usually be lower because the corporation can now issue the bonds possibly at lower rates and pay less in the form of rent interest in essence than they otherwise would if they didn't have the Sinking Fund. So that's gonna be that risk versus the return relationship. So as a result, the company is usually seen as credit worthy which can lead to positive credit ratings for its debt. So that means it's gonna help when you get the credit ratings on it, you would think that that could be a beneficial tool to help with the credit rating as well. Good credit rating increases the demand for a company's bond from investors which is particularly helpful if a company needs to issue additional debt or bonds in the future. So that credit rating is gonna be very important because people rely on the credit rating and if you have a better credit rating on the corporate side of things, then typically you will be able to issue bonds and pay less in terms of rent for the money that you're getting when people loan you in essence the money because of the risk theoretically being lower reflected by the credit rating. So financial impact, lower debt servicing costs due to lower interest rates can improve cash flow and profitability over the years if the company is performing well, investors are more likely to invest in their bonds leading to increased demand and the likelihood that company could raise additional capital if needed. So callable bonds, if the bonds issued are callable it means the company can retire or pay off a portion of the bonds early using the sinking fund when it makes financial sense. So callable is an option typically on the benefit side of the company side of thing so they can call back the bonds possibly in a situation where they have more favorable interest rates on the market after time passes. So the bonds are embedded with a call option given the issue of the right to quote call and quote or buy back the bonds. The perspective of the bond issues can provide details on the callable features including the timing in which the bonds can be called specific price levels as well as the number of bonds that are callable. Typically only a portion of the bonds issued are callable and the callable bonds are chosen by random using their serial numbers. A callable is typically called at an amount slightly above par value and those called earlier have a higher call value. For example, a bond callable at a price of 102 pays the investor $1,020 for each $1,000 in face value. So that 102, you can think of it like 102%, 1.02, 102% times the $1,000 face amount is gonna be the call. So yet stipulations might state that the price goes down to 101 after a year. So if interest rates decline after the bonds issue, the bond can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature. So in essence, this is kind of similar to basically if you had a mortgage and you're trying to refinance the mortgage or something like that, that's kind of what they're doing here. So again, there might be a better rate on the market if they have the capacity to do the callable thing. It's a rigmarole type of process to do it, but you might lock down or they might be able to get access to lower cash flow, lower rates that they'll be paying back. So as a result, the company has refinanced its debt by paying off the higher yielding callable bonds with the newly issued debt at a lower interest rate. Also, if interest rates decrease, which would result in higher bond prices, the face value of the bonds would be lower than current market prices. So in this case, the bonds could be called by the company who redeems the bonds from investors at face value. The investors could lose some of their interest payments resulting in less long-term income. Other types of sinking funds. Sinking funds may be used to buy back preferred stock. Preferred stock usually pays a more attractive dividend than common equity shares. A company could set aside cash deposits to be used as a sinking fund to retire preferred stock. In some cases, the stock can have a call option attached to it, meaning the company has the right to repurchase the stock at a predetermined price. Business accounting and sinking funds. A sinking fund is typically listed as a non-current asset or long-term asset on the company's balance sheet and is often included in the listing for long-term investments or other investments. Companies that are capital intensive usually issue long-term bonds to fund purchases of new plant and equipment. That's kind of the point of when they're trying to gain capital, they're trying to grow, they're trying to expand, they can issue stocks or they can issue bonds. If they issue the bonds, then they're gonna basically, it's kind of a way to get access to capital to put into property, plant and equipment, which hopefully will increase the value of the company through the use of those assets to generate revenue. So oil and gas companies are capital intensive, meaning they need a lot of money in order to pay for all the stuff that it's required to pump the oil and process the oil into gas and all that kind of stuff. So because they require a significant amount of capital or money to fund long-term operations, such as oil rigs and drilling equipment. Real-world example of a sinking fund, let's say for example that Exxon Mobile Corp, XOM issued US $20 billion in long-term debt in the form of bonds. Interest payments were to be paid semi-annually, that's kind of the standard oftentimes for bonds. So they're gonna be paying back just the interest every six months, paying back the principal at the end of the term. So the company establishes a sinking fund whereby $4 billion must be paid to the fund each year to be used to pay down debt. So by year three, Exxon Mobile has paid off $12 billion of the $20 billion in long-term debt. The company could have opted not to establish a sinking fund, but it would have had to pay $20 billion from the profit, cash, or retained earnings in year five to pay off the debt. So the issue here of course, the way it works, we're basically kind of loaning money to the company, but they're not paying it back as we might see in like an installments of equal payments of interest and principal as we might see it like in a loan, but instead they're paying us just the rent, just the interest every six months on it, and then they give us the basically the loan principal back at maturity. So you can see obviously you got this big balloon payment then the receipt of the principal at the maturity date, which you can try to manage in different ways such as possibly a sinking fund. So the company would have also had to pay five years of interest payments on all of the debt. So if economic conditions had deteriorated or the price of oil collapse, Exxon might have had a cash shortfall due to lower revenues and not been able to meet its debt obligation. Paying the debt early via a sinking fund saves a company interest expense and prevents the company from being put in financial difficulty in the long-term if economic or financial conditions worsen. Also, the sinking fund allows Exxon Mobile the option to borrow more money if needed. In our example above, let's say by year three the company needed to issue another bond for an additional capital. Since only $8 billion of the $20 billion in original debt remains, it would likely be able to borrow more capital since the company has had such a solid track record of paying off its debt early.