Sinking Fund is a way for organizations to set money aside over time in order to retire its indentures (obligations from bond agreements).
By using the sinking fund, a company is setting aside portions of money in order to repurchase some of issued bonds when interest rates fall. By doing this, a company makes a safe seat for itself.
For example, if a company issues bonds with $10.000 value and 20 years life span, company will pay coupon payments to the bondholders each year. However, when 20 years period is over and the principal repayments come due, the company must repay $10.000 principal per every issued bond. This could be a big burden for issuing company, especially if it is in poor financial situation.
In order to avoid this large outflow, company will deposit portions of money when in posse, and use them to repurchase and retire a portion of existing bonds every year at specified sinking fund price.
Sinking funds can be a positive for the bondholders because risk of default is significantly smaller, but there is also a risk of repurchasing bonds at sinking fund price, which is usually lower than the call price.
