This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The sinking fund principle first came into prominence in the latter part of the eighteenth century, when it was advocated and applied by William Pitt as the best and easiest means of providing for the repayment of the United Kingdom's huge national debt. It was heralded by many people at the beginning as a remarkable method of repaying the loan without any perceptible sacrifice. As a matter of fact, this is in many instances the truth of the case. Corporations are run by human beings who are more than likely, if left to their own devices, to make inadequate provision for the future. An officer of a corporation which has just floated, let us say, a 25-year loan, is likely to consider that his duty has been done; his corporation has received a large amount of fresh capital which can be profitably used, and the earnings of which (after deducting the interest payments) will go to increase the yield on outstanding stock. It is easy for him to think that it is not his part to worry as to the repayment of the loan. When it begins to approach maturity, he, or his successor, will consider how it should be handled.
Against this everyday human attitude of directors and managers of borrowing corporations, there are opposed the interests of the buyer of the bond and of his representative in the preliminary negotiations, namely the banking firm which undertakes to dispose of the bond issue. The investor wants to make sure that his money will be repaid when due. Further than that, he wants to make sure that there will be no depreciation in the market value of his holdings. He is well aware, as every lender must be, that the borrower's natural instinct is to let the future take care of itself. If he is wise, he is 5trongly inclined to insist that some definite measures be adopted which will fully protect him against the carelessness or easy-going optimism of the people to whom his money has been entrusted.
This wise demand on the part of the investor can readily be met without great difficulty. The fundamental reason for the sinking fund or some other method of beginning at once to repay a loan, is to be found in the fact that comparatively small amounts set aside each year out of the corporation's earnings will assure repayment, unless the corporation has overborrowed. The annual provision, accumulating as it does at compound interest, will not be a serious burden. Accumulating at the rate of 6%, a sinking fund of approximately 4.3% per year will provide for repayment of a loan at the end of 15 years; accumulating at a rate of as little as 3%, a sinking fund of 2.8% per annum will provide for repayment of a loan at the end of 25 years.
A corporation should be able to withhold these amounts and yet have ample funds remaining, if it is reasonably prosperous, for dividends to its stockholders. It is clear from the approximate figures cited, that the repayment of a loan by annual deductions from income is especially appropriate in the case of loans running from 20 to 50 years. The length of the loan will, of course, depend upon the character and stability of the business. A loan to a railroad company may properly run, it is generally considered, for as long as 50 years. A loan to an industrial corporation will ordinarily not run longer than 25 years. Inasmuch as the profits of industrial corporations are expected to average higher than the profits of transportation companies, it is clear that they should be able to carry a larger sinking fund.
Although many corporations combat the tendency, there can be little question but that the demand for some form of sinking fund or other annual repayment is growing. The Committee of the American Investment Bankers' Association on Railroad Bonds and Equipment Trusts, included among its recommendations at the 1915 meeting of the association, that "railroad mortgages should contain provisions for sinking funds, and that such sinking fund payments should be recognized by the rate-making bodies as an operating expense of the railroad corporation".
In popular usage the term "sinking fund" is applied almost indiscriminately to any method of providing for repayment of a long-term loan during its life, by setting aside a predetermined amount at regular periods for that purpose. This process is known in more technical language as "amortization." In its proper sense, amortization includes four principal methods as follows:
1. The borrower may turn over fixed cash payments at regular periods, usually once a year or once every six months, to a trustee; the trustee may deposit or invest the money at his discretion within the limits determined in the original agreement.
2. The borrower may set aside fixed sums at regular intervals and deposit or invest these sums at his own discretion within the limits of the agreement.
3. The borrower may set aside sums at regular intervals and use them solely for the repurchase of the bonds which are being amortized.
4. The bonds may be arranged to mature in series so that a predetermined proportion will fall due each year, thus forcing the borrower to repay the bonds gradually during the life of the whole issue.
The first two methods are the ones originally in view under the sinking fund plan. They are still used to a considerable extent in the repayment of municipal and some other governmental loans, but are seldom to be found in private corporations. The third and fourth methods are in one important respect similar, since the sums set aside out of income are used under both methods for the redemption of the borrower's own obligations, not for the purchase of outside securities. In applying the third method, the bonds which are repurchased by the corporation are frequently kept alive. Interest payments on them are maintained, in which case it may properly be designated as one variety of sinking fund. In other instances the bonds that have been redeemed are cancelled, in which case the third method closely resembles the fourth method.
There are certain objections to all these methods which may briefly be stated. When the first-named plan of turning over regular payments to a trustee is followed, there is always to be considered the possibility that the trustee may invest the funds with a view primarily to his own advantage, or may make unsound investments, in which case it is quite possible that the fund may not accumulate as rapidly as had been expected in advance. The possibility of making unwise investments is almost equally to be feared under the second method. Furthermore, the average rate of return on high-class investments varies considerably over a long period of years, and this may make impracticable even an approach to the rate of accumulation which had been calculated in advance. It is, in fact, a matter of common knowledge that sinking funds invested in outside securities seldom come up to the expectations of those who plan them. The final, and perhaps most serious, objection to both the first and second methods is that high-grade investments, which are the only ones suitable for sinking funds, yield a comparatively small rate of return; as a matter of fact, the rate of interest received on such securities usually is considerably less than the interest which is being paid by the corporation on its own obligations.
These objections have proved so powerful and well founded, that it has come to be almost universally accepted as correct practice to carry on amortization through the redemption of bonds which are being amortized. The practical question for most corporations to consider is whether it is best to set aside fixed amounts for the redemption of their securities, or to arrange for serial maturity of these securities. For short-term loans the tendency is strongly toward the convenience and simplicity of the last-named method. For long-term loans, however, the third method is probably better adapted. There are two fundamental reasons for this preference: first, when an issue of long-term bonds has different dates of maturity, it is necessary to fix a distinct price for each maturity, which is inconvenient and in large part offsets the advantage of ready marketability which should attach to all large bond issues; second, unless the amount falling due at each date of maturity is arranged on a graduated scale so that the amounts become progressively larger, the burden on the corporation is heavier at the beginning when interest payments on the whole issue must be met, and is gradually lightened as more and more of the bonds are redeemed and interest payments are thereby reduced. It is far better, if possible, to retain the advantage of uniformity in the life of all the bonds in one issue, and of an equal distribution of the burden over a period of years, both of which are attractive features of the original sinking fund plan. The simplest and no doubt the favorite device for meeting all these objections, is to establish a sinking fund and invest the fund solely in bonds that are being amortized. Among the beneficial results of this method are the following:
1. The corporation is protected against any loss due to unwise investment, when it is buying its own bonds, and thereby reducing its outstanding obligations. It is certainly in no danger of losing its money.
2. The rate of interest earned is the same as the yield of the market price of the bonds that are being amortized. This is an accurate statement, at least under the customary provisions that the bonds may be redeemed for the sinking fund at par or slightly above, or may be purchased in the open market at the option of the corporation, in case the market price is below the fixed redemption price. If the bonds are selling on a 6 or 7% basis, it is clear that the sinking fund will accumulate at the same rate.
3. Under the customary provisions just referred to, the market price of the bonds is maintained by the corporation's repurchases or redemption, and in this way the credit of the corporation is supported.
4. There is nothing to prevent making a single quotation for all bonds in the issue. If a corporation buys in the open market, it takes whatever bonds happen to be for sale at the market price. If it redeems a fixed proportion of bonds each year, the bonds to be redeemed are customarily determined by lot. In this last practice there is a slight element of uncertainty which might be considered objectionable, but it is of small practical importance.
5. The burden on the corporation is equally distributed during the life of the bond issue. The simplest plan for accomplishing this result is to keep alive all the bonds purchased for the sinking fund, so that the corporation pays out the same amount of interest each year. As the number of bonds held in the sinking fund increases more and more, interest payments, it is clear, go to swell the sinking fund, and thus to increase the annual purchases or redemptions. But so far as the burden on the corporation is concerned, it remains the same year after year.
There seems to be little room for question that among all the methods of amortization, the best and simplest is the one just described of establishing a sinking fund which is used for the repurchase and redemption of all the bonds that are being amortized, and keeping alive the bonds that are taken into the sinking fund.