What it means
Every security that can be repaid has a way of doing so. For a bond, the simplest mechanism is repayment of the face value on the maturity date.
Others allow the issuer to repay early, give the holder the right to demand repayment, or set up a fund to retire the bond in stages. The common types are the call provision, which lets the issuer redeem early at a small premium to face value, and the put option, which lets the holder require repayment on certain dates.
A sinking fund obliges the issuer to set aside cash and retire part of the debt on a schedule, and open-ended funds let investors redeem units at the fund's net asset value (the value of its holdings per unit). For the issuer, the mechanism is a financial planning tool.
A company that expects interest rates to fall may want a call feature so it can refinance more cheaply, while a company that wants stable funding will prefer fixed maturities. For the investor, the same features change the risk, because a bond that can be called early may be repaid just when rates are low and reinvestment is least attractive.
Fees and restrictions are part of the mechanism too. A fund may charge a redemption fee, require notice, or limit withdrawals in a given period to protect remaining investors.
These terms are written in the prospectus or offering document and are worth reading before investing. The nuance is that a security's headline return depends on how it is redeemed.
A bond with a high coupon but a call date soon after issue may deliver far less than the stated yield suggests. Analysts therefore calculate the yield to the earliest call date as well as the yield to maturity.
Tax and accounting treatment can also depend on the mechanism. Redeeming a bond at a premium or discount to its carrying value produces a gain or loss that has to be recorded, and early redemption can accelerate the write-off of issue costs.
Treasurers therefore model the accounting effect before they exercise a call.
In practice
Real-world examples.
Example
A corporate treasurer issues a 10-year bond with a call provision that lets the company repay it after five years at 102% of face value. Interest rates fall in year six, so the company redeems the bond and issues a new one at a lower rate.
Example
An investor in an open-ended fund submits a redemption request on Monday and receives the proceeds at the Monday closing net asset value, less a small fee. The fund's terms require three days' notice for large withdrawals.
Example
A utility company agrees a sinking fund for its bonds, retiring $5,000,000 of the issue each year. Bondholders are reassured that the debt will be steadily repaid instead of falling due in one large sum.
Formula
Calculation
Redemption proceeds = (units redeemed x net asset value per unit) - redemption fee
Suppose an investor redeems 2,000 fund units when the net asset value is $25 per unit, and the fund charges a 1% redemption fee. Gross value = 2,000 x 25 = $50,000. Fee = 50,000 x 0.01 = $500. Redemption proceeds = 50,000 - 500 = $49,500. The same logic applies to any redemption, since the amount received equals the value of the units less any charge, so the fee is the only part the investor can reduce by choosing a different fund or a longer holding period.Case study
Seen in the real world.
Harlow Pine Capital is an illustrative, fictional property fund that allowed investors to redeem units monthly. In a year when property values dipped, many investors asked for their money back at the same time.
The fund's managers did not have enough cash because property cannot be sold quickly. Under the terms of the redemption mechanism, they limited withdrawals in that month to 10% of the fund and paid the rest in later months, which protected investors who remained.
Some investors were unhappy, but the terms had been disclosed in the offering document. The illustrative lesson is that a redemption mechanism has to match the liquidity of the assets behind the security. The managers later added a plain-English table to the fund's brochure showing exactly how the monthly limit would work, so that investors could see in advance what they might receive.
Watch out
Common mistakes.
- Assuming a bond will always run to maturity, when a call provision may allow early repayment.
- Ignoring redemption fees and notice periods when planning to withdraw from a fund.
- Quoting yield to maturity for a callable bond without checking the yield to the earliest call date.
Questions
People also ask.
What is the difference between a call and a put?
A call gives the issuer the right to redeem early, while a put gives the holder the right to demand repayment.
Why do funds limit redemptions?
They may need to protect remaining investors when assets cannot be sold quickly enough to meet a rush of withdrawals.
Where are the redemption terms written?
In the bond indenture, prospectus or offering document, which every investor should read before buying.
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