What it means
When a company issues a bond it is borrowing, and redemption is simply the day it pays the money back. Most bonds redeem at par, meaning the face value stated on the instrument, on a fixed maturity date.
Between issue and redemption the investor receives interest, and the redemption payment settles the principal. Many instruments allow earlier repayment, which is where the commercial interest lies.
A callable bond lets the issuer redeem early, usually at a price above par to compensate the investor for losing future interest, and issuers exercise that right when interest rates have fallen and they can refinance more cheaply. A puttable bond gives the same early exit right to the investor instead.
The compensation built into early redemption is the call premium, expressed as a redemption price such as 103, meaning 103% of face value. Investors watch this closely because a bond bought above its call price can produce a loss if the issuer calls it, which is why yield to call sits alongside yield to maturity in any sensible analysis.
Redemption means something slightly different in funds. An investor redeeming units in an open-ended fund sells them back to the fund itself, which must find the cash, sometimes by selling underlying assets.
Heavy redemptions in a fund holding illiquid assets such as property are what force temporary suspensions of dealing. Preference shares and loan notes sit between these worlds.
Redeemable preference shares carry a defined repayment date or a company option to buy them back, and are often accounted for as debt rather than equity precisely because the money has to be returned. The label on the certificate matters less than whether repayment is obligatory.
In practice
Real-world examples.
Example
A city transport authority redeems a $40,000,000 bond issue at par on its scheduled maturity date, funded from a sinking fund it has been building for a decade. Bondholders receive their capital plus the final coupon, and the debt disappears from the balance sheet.
Example
A manufacturer calls its 8% loan notes two years early at a redemption price of 102, replacing them with new borrowing at 5.25%. The $12,000,000 issue carries a call premium of $240,000 up front, but the 2.75 percentage point saving is worth $330,000 a year, or $660,000 across the two remaining years.
Example
A property fund faces redemption requests from investors totalling 14% of its net asset value in a single month. Unable to sell buildings quickly enough, it suspends dealing for six months, which protects remaining investors from a forced sale at distressed prices but locks in those who wanted out.
Formula
Calculation
Redemption payment = number of instruments x (face value x redemption price percentage), plus any accrued interest to the redemption date.
Halcyon Utilities issued 5,000 bonds of $1,000 face value each, so $5,000,000 of debt, carrying a 6% annual coupon paid every six months. The bonds are callable at 103 after five years, and with market rates having fallen, the company calls them three months after the most recent coupon payment.
The redemption price per bond is $1,000 x 103% = $1,030, so the principal element is 5,000 x $1,030 = $5,150,000. That includes a call premium of $5,150,000 - $5,000,000 = $150,000, the cost of buying back early. Accrued interest for the three months since the last coupon is $5,000,000 x 6% x 3/12 = $75,000. The total cash paid on redemption is $5,150,000 + $75,000 = $5,225,000, and Halcyon judges the premium worthwhile because refinancing at a lower rate saves more than $150,000 over the remaining term.Case study
Seen in the real world.
Selby Renewables is a fictional company created to illustrate how redemption decisions are made. It had raised $12,000,000 through a seven year bond at 7.5%, callable at 102 from year four, at a time when its wind projects were unproven and lenders demanded a high rate.
By year four the projects were operating reliably and the company's credit standing had improved considerably, while general interest rates had also drifted downwards. Selby's finance director found she could issue new seven year bonds at 4.75%. Calling the old issue cost $12,240,000 in principal, a call premium of $240,000, plus about $110,000 in issuance fees on the new bonds.
Against that, the interest saving was $12,000,000 x 2.75% = $330,000 a year, so the $350,000 of combined costs was recovered in a little over a year, leaving nearly two further years of saving beyond that. In this illustrative case the decision was straightforward, but it depended entirely on the call premium being modest relative to the rate improvement, which is the calculation every issuer runs.
Watch out
Common mistakes.
- Assuming a bond will run to its stated maturity date, when a callable bond may be redeemed early precisely when reinvestment rates are least attractive.
- Quoting yield to maturity for a callable bond trading above its call price, which overstates the return an investor is likely to actually receive.
- Treating redeemable preference shares as equity for gearing purposes when the obligation to repay makes them behave, and often be classified, as debt.
Questions
People also ask.
What does redemption at par mean?
It means the issuer repays the face value stated on the instrument, so a $1,000 bond redeems for exactly $1,000 plus any interest accrued.
Why would a company redeem debt early if it costs a premium?
Because refinancing at a lower interest rate can save more over the remaining term than the premium costs, and because removing restrictive covenants has value of its own.
Can a fund refuse to let me redeem my holding?
In defined circumstances yes; many funds holding illiquid assets have powers to defer or suspend redemptions to avoid selling assets at distressed prices.
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