Editing Sinking fund (section)

==Modern context &ndash; bond repayment==
In modern finance, a sinking fund is, generally, a method by which an organization sets aside money over time to retire its indebtedness. More specifically, it is a fund into which money can be deposited, so that over time [[preferred stock]], [[debenture]]s or stocks can be retired. See also "sinking fund provision" under [[Bond (finance)#Features]].

In some US states, [[Michigan]] for example, school districts may ask the voters to approve a taxation for the purpose of establishing a sinking fund. The State Treasury Department has strict guidelines for expenditure of fund dollars with the penalty for misuse being an eternal ban on ever seeking the tax levy again.

===Types===
A sinking fund may operate in one or more of the following ways:
# The firm may repurchase a fraction of the outstanding bonds in the open market each year.
# The firm may repurchase a fraction of outstanding bonds at a special call price associated with the sinking fund provision (they are [[callable bond]]s).
# The firm has the option to repurchase the bonds at either the market price or the sinking fund price, whichever is lower. To allocate the burden of the sinking fund call fairly among bondholders, the bonds chosen for the call are selected at random based on serial number. The firm can only repurchase a limited fraction of the bond issue at the sinking fund price. At best some indentures allow firms to use a ''doubling option'', which allows repurchase of double the required number of bonds at the sinking fund price.
# A less common provision is to call for periodic payments to a trustee, with the payments invested so that the accumulated sum can be used for retirement of the entire issue at maturity: instead of the debt [[Amortization (accounting)|amortizing]] over the life, the debt remains outstanding and a [[Matching principle|matching]] asset [[accrue]]s. In this way a fund is built up with the intention of paying off the debt in full at a specified future date instead of directly paying the debt down over time. This method was popular in the 1980s-90's in the UK household [[Endowment mortgage|mortgage]] market.

===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, so that the organization does not need to pay a large amount of money when due, and thus a heavy disruption to the financial position of the organization can be avoided. For the creditors, the fund reduces the risk the organization will default due to financial hardship caused by the large payment, 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 (finance)|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.