G
A sinkhole eats cars. A sinking fund eats debt. All things considered, most people would prefer to sink the latter. Photo: Mike Licht via Flickr.

The financial world is full of strange and seemingly self-contradictory terms. Share split. Reverse mortgage. Zero coupon bond. One of the strangest is the "sinking fund."

It sounds kind of scary -- conjuring mental images of the Earth opening up and swallowing your money -- but it's actually not scary at all. In fact, when a company implements a sinking fund, it can be pretty good news for bond investors.

Brother, can you spare a dime? Can you spare 1 billion dimes?
Companies that need money to expand their business, hire new employees, or even just pay off debt, sometimes issue new debt in the form of bonds. As a general rule, the company will sell bonds to investors, promise to pay interest on those bonds over a term of years, and ultimately pay back all of the principal it borrowed as well.

But here's the thing: Say a company needs to borrow $100 million today, and sells $100 million worth of bonds to raise that cash, promising to pay it back 10 years from now. If the company didn't have $100 million handy today, where's the assurance that they'll be any more cash-flush 10 years from now, and able to pay back the $100 million it borrowed when that money comes due?

The answer: The company might create a sinking fund.

What is a sinking fund?
To ensure it can pay back a big debt when it comes due -- and to reassure the people buying its bonds that it will be able to do so -- a company that issues bonds might begin getting ready to pay back that debt on Day 1, as soon as it gets the money.

It does this by establishing a sinking fund. Every year, the company takes a bit of money from its earnings and pays it to a trustee. That trustee might be instructed to hold onto the cash, accumulate it, and save it for the date when the whole debt comes due. Or the trustee might spend the money to periodically buy back the bonds that have been issued, ahead of schedule -- thus reducing the size of the debt that must be paid on the due date.

So in a sense, a "sinking" fund is actually a typo. It's actually more of a "shrinking" fund. It's a way for a company that has issued a bond, and incurred a debt to its investors, to shrink the size of that debt over time -- so that when the bond finally comes due, there's a whole lot less debt that must be paid off all in one go.

So is a sinking fund good or bad?
I suppose you could argue a sinking fund isn't all good, because it prevents a company from putting all the money it borrows to good use growing its business. Some bond buyers might also not be thrilled to have their bonds bought back early ("called" in industry parlance), depriving them of the interest payments they were expecting in future years, and forcing them to find new places to invest their money.

But still, the presence of a sinking fund backing a bond issue increases the likelihood that the debt will ultimately be repaid -- and that you, the bond investor, will get your money back. That's undeniably a good thing. And because investors have more reassurance of getting their money back, the value of bonds backed by a sinking fund tends to be higher, and the interest rate a company must pay to sell its bonds tends to be cheaper -- lowering the company's cost of borrowing.

All things considered, a sinking fund seems a net "plus" for both companies issuing bonds, and for the investors who buy them.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 260 out of more than 75,000 rated members.

The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.