Overview
In the realms of finance and business, redemption holds different meanings. In fixed-income instruments, redemption can be described as the repayment of any fixed-income security on or before its maturity date.
Redemption is the process of paying back or returning something that was borrowed or purchased earlier. In finance, it often refers to the repayment of a debt or the return of the initial investment amount.
What is Redemption in Bonds?
Bond redemption is the process of repaying the bond’s principal amount to the bondholders when the bond matures or when the issuer decides to call the bond before its maturity date in case of a callable bond.
When the bond reaches its maturity date (the end), you usually get the full face value. But if you cash out early, you might get more or less than you invested.
Bond redemption is a significant event for bondholders, as it signals the end of the bond’s life cycle and the return on their investment. The redemption date and face value are already predetermined in the information memorandum at the time of issuance.
Redemptions can sometimes result in capital gains or losses, impacting your overall tax liability.
Offsetting Capital Gains with Capital Losses
One of the tax advantages of bond investments is the ability to offset capital gains with capital losses. If you incur a capital loss within the same year as a capital gain, you can use the loss to reduce the taxable amount of the gain. This can significantly lower your overall tax liability.
Let’s understand the capital gains and losses associated with redemption with an example.
Suppose you purchase bonds with a face value of INR 50,000 at a discounted price of INR 40,000. When you redeem this bond at maturity, you make a profit of INR 10,000, which is classified as capital gains.
Conversely, imagine you buy a bond with a face value of INR 60,000 at a premium price of INR 65,000. If you redeem this bond for its face value at maturity, you incur a loss of INR 5,000 on this investment. This capital loss can offset your capital gains, thus reducing your tax liabilities on the investment.
Different Types of Bond Redemption
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Maturity Redemption
This type of bond redemption is the most common, where the issuer pays the bondholder the face value of the bond at maturity. For example, suppose a bond has a face value of INR 1,000 and matures in 10 years. In that case, the issuer will pay the bondholder INR 1,000 at the end of the 10th year, and the bondholder will keep receiving periodic interest payments throughout the bond’s term-based on the bond’s coupon rate and payment frequency.
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Call Redemption
This type of bond redemption grants the issuer the right, though not the obligation, to redeem the bond before its maturity date at a specified call price by repaying the principal amount. Typically, this call price exceeds the bond’s face value, compensating the bondholder for early redemption. The issuer may exercise this option when interest rates decrease than the bond coupon rate, enabling them to fulfill capital requirements at a reduced cost. Another scenario prompting the bond’s redemption could be an improvement in the company’s credit rating, allowing for borrowing at a lower coupon rate. Bonds with such options are termed Callable Bonds.
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Put Redemption
This type of bond redemption grants the bondholder the right, though not the obligation, to sell the bond back to the issuer before the maturity date at a specified put price.
Bondholders may exercise this option when interest rates are on the rise, and they expect a decrease in the bond’s value, seeking to reclaim their principal before such a decline occurs and reinvest the proceeds in a higher-yielding bond. The issuer includes a put option in the bonds to attract potential investors to purchase the bond or to benefit from obtaining a lower coupon rate. Bonds featuring such options are termed Puttable Bonds.
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Conversion Redemption
In the conversion bond redemption method, the bondholder can convert the bond into a specified number of shares of the issuer’s common stock at a predetermined price, known as the conversion price. It allows bondholders to exchange their bonds for equity in the company.
Conversion redemption is a feature of convertible bonds, which have the characteristics of both debt and equity and carry a lower coupon rate than other types of bonds. These bonds provide the stability of fixed-income investments while also providing the potential for capital appreciation through equity ownership in the issuing company.
For example, if you purchase a 10-year bond with a face value of INR 1,000 and at a 4% coupon rate, and have the option to convert the bond into 20 shares of the issuer’s stock at a conversion price of INR 500 per share. This method is typically used with convertible bonds, which offer a lower coupon rate than non-convertible bonds to compensate the issuer for the conversion risk.
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Staggered Payments Redemption
When a bond is issued, the issuer commits to paying regular interest and repaying the principal amount at a predetermined future date. However, there are instances where the issuer opts to repay the principal in gradual installments over a period, rather than in one lump sum at maturity. This approach may be chosen to manage large issuances more effectively or to align with anticipated cash flows from underlying assets. Typically, these installment payments are uniform and spaced evenly throughout the bond’s remaining lifespan.
Investors interested in such bonds often prioritize assessing the average life rather than the stated maturity. This is because the gradual repayment schedule means investors may not receive the principal until after the stated maturity, making it crucial to gauge the expected timing and amount of cash flows accurately.
By investing in bonds with staggered maturity dates, investors can spread out their investments across different interest rate environments. When interest rates rise, the shorter-term bonds in the portfolio mature and can be reinvested at higher rates, while longer-term bonds continue to provide a steady income stream. Conversely, during rate declines, longer-term bonds offer stability and comparatively provide higher yields.
For instance, imagine an investor building a bond ladder ranging from 1 to 10 years in maturity. Should interest rates increase after a year, the investor can reinvest the maturing 1-year bond at the prevailing higher rate, while still benefiting from the continued income of longer-term bonds. This allows investors to seize opportunities presented by rising rates while minimizing the impact of interest rate fluctuations.
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Sovereign Gold Bonds Redemption
Sovereign Gold Bond (SGB) premature redemption: An investor can prematurely redeem his/her SGB investment at the end of 5 Years from the issue. However, there is no exemption on tax if it is applied for premature redemption.
The RBI opens the SGB buyback window every year starting from the fifth year of the said SGB tranche. Though the tenor of the bond is 8 years, early encashment/ redemption of the bond is allowed after the fifth year from the date of issue on coupon payment dates.
What is the deadline to tender SGBs for premature redemption by the RBI?
SGB investors are given a specific annual deadline to apply for premature redemption after holding the completion of 5 years of investment. If an investor fails to tender the SGB to the RBI within this deadline, then the said SGB cannot be redeemed in that particular year, and the investor must wait for the next premature redemption window.
In case of premature redemption, investors can approach the concerned bank, SHCIL office, Post Office, or agent thirty days before the coupon payment date. SGB investors need to submit their requests for premature redemption within a specific timeframe, informing the concerned Receiving Office, Bank, SHCIL, or Post Office by the 29th day before the Coupon Date.
SGB investors will be provided with a premature redemption window starting from the fifth year of the bond, around the time of the interest payment date.
According to RBI’s operational guidelines to banks and other institutions, requests for premature redemption of SGBs must be submitted to the Receiving Office or Depository through the Depository Participant (for those held in Demat accounts) at least 10 days before the next interest payment date. This is why there is a 10-day buffer period before the coupon date.
The rationale for the 10-day gap between the interest payment of an SGB and the last date to offer it for premature redemption is used as a buffer period in case anything else is required from the SGB investor that allows the Receiving Office, Depository Participant, or Depository to request additional documents, KYC proof, declarations, or other necessary information from the SGB investor.
How is the redemption price of SGB calculated?
The redemption price is calculated based on the average of the closing prices of 999 purity gold, as reported by the India Bullion and Jewellers Association, over the three business days preceding the redemption date.
Factors Affecting Bond Redemption
The key factors affecting bond redemption are the following:
Interest Rate– Interest rate changes affect bond price and yield. When interest rates increase, bond prices fall, and vice versa. These fluctuations influence either the issuer or the bondholder to redeem the bond before maturity. For instance, if interest rates decline, a callable bond issuer might choose to redeem it and issue new bonds at a reduced interest rate. Conversely, if interest rates rise, the holder of a puttable bond might opt to redeem the bond and invest in a higher-yielding bond.
Credit Rating– The issuer’s credit ratings impact the risk and return associated with a bond. When an issuer’s credit rating improves, the risk of default decreases, leading to an increase in the bond’s price. Conversely, if an issuer’s credit rating declines, the risk of default increases, resulting in a decrease in the bond’s price. These changes in credit ratings also influence the likelihood of bond redemption. For example, if an issuer’s credit rating improves, they may choose to redeem callable bonds and issue new bonds at lower interest rates. Conversely, if an issuer’s credit rating deteriorates, bondholders of puttable bonds may decide to redeem them to avoid further losses.
Tax Changes- Changes in tax treatment have an impact on the after-tax return of bonds. When tax rates change, the after-tax return of a bond changes accordingly; this influences decisions regarding bond redemption. For instance, if tax rates increase, the after-tax return of a taxable bond decreases, prompting the bondholder of a puttable bond to consider redeeming it and investing in a tax-exempt bond. Conversely, if tax rates decrease, the after-tax return of a tax-exempt bond decreases, leading the issuer of a callable bond to redeem the bond and issue new taxable bonds at a lower interest rate.
Conclusion
Summing up, the redemption of bonds can be said to be the end of an investor’s journey, where they receive the principal amount invested along with any accrued interest. It is the fulfillment of the issuer’s obligation and emphasizes the importance of timely repayment in maintaining trust and credibility in the market. Investors need to understand the concept of redemption to make informed decisions and navigate the bond market effectively.
A bond issuer may choose to redeem a bond early for various reasons, such as changes in interest rates, shifts in the issuer’s financial situation, or the desire to refinance the bond at a lower interest rate.
Overall, bond redemption is a crucial aspect of the bond market, enabling issuers to manage their debt and offering investors a way to receive their principal investment.
Disclaimer: Investments in debt securities/ municipal debt securities/securitized debt instruments are subject to risks including delay and/ or default in payment. Read all the offer-related documents carefully.
FAQs
Q1. What is bond redemption?
Ans: Bond redemption is the process of repaying the bond’s principal amount to the bondholders, which occurs either when the bond reaches its maturity date or when the issuer opts to call the bond before maturity in the case of a callable bond.
Q2. Are there different types of bond redemption?
Ans: Yes, there are different types of bond redemption. They are call option, put option, conversion redemption, redemption of Sovereign Gold Bonds, and Staggered redemption.
Q3. What happens to bonds on maturity?
Ans. A bond’s term to maturity is the period during which its holder will receive interest payments on the investment. When the bond reaches maturity, the owner is repaid its par, or face value. The term to maturity can change if the bond has a put or call option.
Q4. What does redeemed at a premium mean?
Ans. If the redemption proceeds are more than the face value of the Bond/NCD, they are said to be redeemed at a premium.
