A sinking fund is an account set-up by a municipality to redeem or purchase its bonds prior to maturity. By having a sinking fund, a municipality can reduce its debt load over time, avoiding the need to finance a large lump sum when the bond reaches maturity. Typically, a municipality is required to put a certain amount in the sinking fund every year, as described by the bond offering statement. Depending on how the sinking fund is set-up, it may be used to purchase bonds on the open market, or by exercising the bond’s call feature. (You can learn more about callable bonds here.)
There is good side and bad side to a sinking fund for bondholders:
- The good side is that a sinking fund reduces the chance that a municipality will not able to meet their debt obligations, by enforcing fiscal discipline over the term of bond.
- The bad side is that there is a fairly high chance that your bond will be called before maturity, and you will face re-investment risk (not being able to receive the same interest rate as when you invested in the bond).
Super Sinking Fund
When investigating sinking funds, you may also hear about super sinking funds. A super-sinker is specifically related to single family mortgage revenue bonds. Funds gathered through the prepayment of mortgages go into the super sinker. Otherwise, a super-sinker operates likes a normal sinking fund.