Redemption
Redemption is when a fixed-income security gets repaid at the time or before the underlying asset reaches maturity. The most common securities of such type are bonds, among others that include certificates of deposit (CDs), Treasury notes (T-notes), and preferred shares. Ordinary consumers deal with redemptions as products or services received in exchange for a coupon or gift card.
Redemptions explained
Most common understanding of redemption is in the context of security investments. Fixed-income securities - like bonds - earn regular interests to their holders and have to be fully repaid at the stated date of maturity. At the arrival of maturity, investors are paid the initial value of the bond declared at this issuance - in financial terms, its par value, or face value. This amount is promised to be repaid by the issuing company, or the borrower of bondholders’ money.
Redeemable bonds are also named callable, which comes from the issuer’s right to redeem the bond before its maturity. In this case, the business rebuys the bond from the holder for the set redemption value. Callable bonds give companies an opportunity to pay off their debt to investors earlier, so issuers can hugely benefit from a plausible financial or market situation - e.g. when interest rate sets low.
Similarly, redemptions take place in mutual funds. Fund members can request from their agent to redeem any time, by doing so they literally sell their shares back to the company. Their request should be accepted and processed within several days before they are distributed the money from the fund. The redemption amount is normally the market value of the fund unit for the day of the request minus the fund's commission, or redemption fee.
It is not only professional investors who can receive a redemption. Today, customers in a lot of market sectors can get a gift certificate or a voucher. They confirm some money deposit in a company too, and any one who presents them receives the redemption in the form of goods or services.
Capital returns with Redemptions
Depending on when redemptions are received, they bring to investors a capital gain or a loss. Like any other income, realized gains on investments are subject to federal government tax. While mutual funds combine all gains and losses in one calculation, in case with fixed-income investments, losses can be used to offset the taxes owed.
To figure the return on investment, a holder needs to know the tax basis, or the par value of the bond, which is not always the same as its purchase price. Let’s say, one buys a corporate bond with the par value of $1000 for $1050. When selling it back at maturity, they receive the par value and trigger a loss of $50. Assume that the investor's portfolio has another $1000 bond, purchased at a discount of 10% - for $900. At the year-end, the investor redeems $1000, generating a gain. As the $100 pocket difference is subject to tax, the investor can report their losses to reduce the capital gain tax.
Of course, the bond holder could have sold their first bond to reduce the loss, but, in this case, their tax on income would be higher. Oppositely, if one does not have any losses, but wants to lower the taxes owed, they may choose to deliberately sell bonds for loss (see an article on so called Tax-loss Harvesting here). It is recommended to discuss investment options with a consultant before attempting any of the strategies, as they can easily backfire even on experienced investors.
Forms of Redemptions
Redemptions in cash. As a rule, redemptions are made through checks or a direct money deposit to the investor's bank account. The money is redeemed in several days after a mutual fund investor requests from their manager to cash in.
It is important for sell orders to be placed before the market closes because, unlike stocks, mutual funds trade only once a day. After the close of trading, the fund is priced and its net asset value (NAV) for that day declared. Mutual fund clients then receive their payouts with all the capital gains based on NAV. It stands for the total amount of assets less all liabilities and defines the pricing of each share.
Some funds apply a back-end load - charges incurred by investors when they redeem. This must be treated as a commission on the sale of investments. Expressed as a percentage of the share value of the fund, it can either be flat or decrease over the holding period. The longer investors hold onto their shares, the less redemption fees they will be charged.
Redemptions in-kind. Another type of redemption is payments made in-kind. While these are not typical for mutual funds, in-kind transactions appear in exchange traded funds (ETFs), whose units are exchanged for a basket of securities rather than cash. For this reason, ETFs are preferred over mutual funds, especially with long-term investments. Issuing shares in-kind, ETFs avoid having to sell securities for redemption payouts, which, in turn, makes investment gains tax-free. So when a holder decides to exit the fund, they are offered other positions pro rata to the positions in the ETF's portfolio.
