Sinking fund

A sinking fund is a provision written into a bond indenture that requires the issuer to set aside money regularly and use it to retire a portion of the bond issue before its final maturity date, rather than repaying the entire principal in one lump sum at the end. The issuer might be required to redeem a fixed percentage of the outstanding bonds each year, either by buying them back in the open market or by calling them from bondholders at a specified price.

The provision benefits both sides. For the issuer, spreading out principal repayment over time reduces the risk of struggling to come up with the full amount at maturity all at once. For bondholders, it reduces credit risk by making a sudden default at maturity less likely, since the debt burden is gradually reduced well before the final due date rather than remaining at full size until the very end.

A sinking fund provision does introduce a version of call risk and reinvestment risk for the bonds selected to be redeemed early, since those bondholders get their principal back sooner than expected and have to reinvest it, potentially at a less attractive rate. Because of this, bonds with sinking fund provisions are sometimes priced slightly differently than otherwise similar bonds without one, and investors evaluating them need to factor in the possibility of earlier repayment on at least part of their holding.