Sinking Fund - Benefits and Drawbacks

Benefits and Drawbacks

For the organization retiring debt, it has the benefit that the principal of the debt or at least part of it, will be available when due. For the creditors, the fund reduces the risk the organization will default when the principal is due: it reduces credit risk.

However, if the bonds are callable, this comes at a cost to creditors, because the organization has an option on the bonds:

• The firm will choose to buy back discount bonds (selling below par) at their market price,
• while exercising its option to buy back premium bonds (selling above par) at par.

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 higher coupon rate, reflecting the value of the option.