Securities redemptions can occur when a security matures, when the security is canceled prematurely by the borrower using a mandatory call, or through refinancing using an optional call. Borrowers can redeem a security prior to maturity by purchasing the security in the open market with an open market purchase, by calling the security via the proceeds of a new bond issue known as a refunding, or with cash on hand, also called a cash defeasance.
There are several types of redemption provisions associated with a debt security:
- Redeem at maturity: The investor receives the face amount of the security from the borrower on the stated maturity date.
- Early Redemption: Callable securities offer borrowers the option to redeem part or all of a security before maturity. An optional redemption lets the borrower redeem the securities early, possibly at a premium. This callable option may only be exercised at specified times, usually after a certain period has elapsed — such as 10 years. Borrowers will generally redeem a callable security when interest rates for similar securities fall below a security’s coupon rate. The borrower can save money by paying off the security and issuing another security at a lower interest rate, similar to refinancing a mortgage.
- Mandatory Redemption: The borrower is required to redeem an entire issue or a portion of its outstanding issues before maturity. Some types of mandatory redemptions occur on a predetermined basis. Securities are redeemed at a specified price, often at par, plus interest accrued before the redemption date. Another type of mandatory redemption occurs when a specified amount of money for a mandatory sinking fund payment of a term security is set aside.
- Extraordinary Redemption: An extraordinary redemption allows a security to be redeemed early if certain extraordinary events occur, such as an earthquake or fire that damages or destroys the funded project. These events are specified in the offering statement. Extraordinary redemptions, sometimes called extraordinary calls, may also occur when security proceeds aren’t spent according to schedule or when security proceeds are used in a way that makes non-taxable security interest taxable. Extraordinary redemptions may be optional or mandatory.
Example:
The City of Cloverton has an optional redemption date on 1/1/2023 of its $20,000,000 debt security issue with a 4.00% coupon rate. Cloverton needs $20,000,000 to cover the security’s issue principal. The City must also pay the interest owed on the bond of half the 4.00% rate (one semi-annual interest payment) or $400,000.
This means that Cloverton needs $20,400,000 for this optional redemption. The City will often borrow the $20,400,000 needed for this optional redemption at a lower rate (3.00% rather than 4.00%) which results in a lower overall financing cost for the city.
What’s important here?
When an investor purchases a bond, there is the possibility that the borrower will either wait until the bond matures to repay the investor the principal, or pay the bond principal off prior to the final maturity using several refinancing techniques.