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Sinking funds are special reserves set aside by companies that issue stocks and bonds. The main function of a sinking fund is to eventually be in a position to retire shares of preferred stock, debentures, or any outstanding bond issues. In most cases, the company will incrementally add resources to the fund over an extended period of time, allowing the balance in the fund to keep pace with the shares of issued stock or the worth of active bond issues.
There are several advantages to the creation of a sinking fund. First, it is much easier to attract investors. This is because the investor knows that any shares of stock or bond issues associated with the company are backed by the resources in the fund. As a result, the potential for some sort of default action on behalf of the issuing company is greatly minimized.
Another benefit to having a sinking fund to back bonds and stocks is that the company positions itself to retire the financial instrument when and as it becomes advantageous to do so. Investors are paid out of the resources housed in the fund, which prevents the company from pulling resources from other sources or having to cut production of marketing in order to manage the call. From this perspective, investors will yield at least whatever return they are due at the point the call is issued and the company is not placed into financial distress as a result of retiring the instrument.
While many people tend to associate the shrinking fund with the issuance of stocks, the device is also commonly employed with bond issues. A sinking fund bond, like the stock that is backed by the resources of this type of fund, is a more secure investment than other bond issues, simply because the investor has virtually no worries about earning a return from the bond issue. Sinking fund bonds are preferred by many investors simply because they know the terms of the bond will be fulfilled with little to no waiting periods or other inconveniences that could occur if the bond issuer was undergoing some sort of financial difficulty.
One sinking fund factor that is sometimes overlooked is the potential for sinking fund depreciation. The depreciation can come about due to changes in the marketplace in general, shifts in the performance of the issuing company, or even political situations that impact the value of the currency for a period of time. Still, many companies know of ways to minimize the impact of these sorts of factors, thus protecting the overall integrity of the sinking fund.