Sinking Funds of Long Term Financing

"Fund established to periodically retire a portion of a security issue before maturity. The corporation is required to make periodic sinking-fund payments to a trustee".

The majority of corporate bond issues carry a provision for a sinking fund that requires the corporation to make periodic sinking-fund payments to a trustee in order to retire a specified face amount of bonds each period. The corporation can make a cash payment to the trustee, which in turn calls the bond for redemption at the sinking-fund call price.(This is usually lower than the regular call price of a bond, which we discuss shortly.) The bonds themselves are called on a lottery basis by their serial numbers, which are published in the wall street journal and other newspapers. The second option available to the issuing firm is to purchase bonds in the open market and to deliver a given number of bonds to the trustee.

The corporation should purchase the bonds in the open market as long as the market price is less than the sinking-fund call price. When the market price exceeds the call price, it should make cash payment to the trustee. if interest rates increase and / or credit quality deteriorates, the bond's price will decline in relation to the sinking-fund call price. As a result, the option of the corporation to deliver either cash or bonds to the trustee can have significant value. As with any option, the option feature works to the advantage of the holder-in this case the corporation- and to the disadvantage of the bond holders. The greater the volatility of interest rates and / or the volatility of the firm's value, the more valuable the option to the corporations.
Sinking-fund payments don't necessarily retire the entire bond issue.

There can be a balloon payment "(a payment on debt that is much larger than other payments. The ultimate balloon payment is the entire principal at maturity)" at final maturity.