What is the function of a sinking fund?

A sinking fund's primary purpose is to lower risk for both the issuer and investors. It operates as a financial strategy where the issuer sets aside funds over time to repay a portion of a bond's principal before its maturity. By doing so, the issuer reduces the risk of default because there is a committed mechanism in place to ensure that the necessary funds will be available to meet debt obligations. This arrangement can also enhance the overall credit quality of the bond, making it more appealing to investors as it mitigates concerns about the issuer's ability to repay the debt at maturity.

The mechanism not only helps protect investors by providing a level of assurance regarding the repayment of principal but also benefits the issuer by potentially lowering its cost of borrowing. This reduced risk can lead to favorable borrowing terms and lower interest rates on future debt issuances.