Sinking Fund Provisions
A bond covenant requiring the issuer to retire part of the issue on a schedule before final maturity, reducing the amount investors are exposed to at the end.
A sinking fund provision is a covenant in a bond's indenture that requires the issuer to retire a portion of the outstanding issue on a set schedule before the stated final maturity date, rather than repaying the entire principal in one lump sum at the end. Typically the issuer sets aside cash annually and either buys back a fraction of the bonds in the open market or retires them by lottery among bondholders at par, chipping away at the outstanding amount year by year.
From an investor's perspective, a sinking fund reduces credit risk by spreading out the repayment burden — the issuer never has to find 100% of the principal in a single year — but it also introduces reinvestment and call-like risk, since bonds selected for early retirement are usually redeemed at or near par regardless of where they're trading, which hurts a holder who bought the bond at a premium. For example, a $500 million bond issue with a 5% annual sinking fund requirement would see $25 million retired each year, so only a fraction of the original issue is still outstanding by the time the stated maturity arrives.
A sinking fund provision forces an issuer to retire part of a bond issue on a schedule before final maturity, lowering the issuer's credit risk at the end but exposing investors who paid a premium to the risk their bonds get called back at par early.
Further reading
- Fabozzi, Bond Markets, Analysis, and Strategies