Redemption: Definition in Finance and Business

What Is Redemption?

Depending on the context, the term redemption has different uses in the finance and business world. In finance, redemption refers to the repayment of any fixed-income security at or before the asset's maturity date. Bonds are the most common type of fixed-income security, but others include certificates of deposit (CDs), Treasury notes (T-notes), and preferred shares.

Another use of the term redemption is in the context of coupons and gift cards, which consumers may redeem for products and services.

Understanding Redemptions

People who invest in fixed-income securities, such as bonds, receive fixed interest payments at regular intervals. Bonds can be redeemed before or on their maturity date. If redeemed at the time of maturity, an investor receives the par value (also called the face value) of the bond. This refers to the original value of the bond when it was first issued and is the amount of money the issuer of the bond agrees to repay the bondholder.

A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches its stated maturity date. Redemption value is the price at which the issuing company will repurchase the bond from investors before its maturity date. A callable bond allows the issuer of the bond to pay off its debt early. An issuer may choose to call their bond if market interest rates move lower.

A mutual fund is another example of an investment that an investor can redeem. To make a mutual fund redemption, the investor must inform their fund manager of their request. The manager must process the request within a certain amount of time and distribute the funds to the investor. The amount owed to the investor is normally the current market value of their shares less any fees and other charges.

As consumers, we often make redemptions in our everyday lives. For example, a coupon or gift card is a form of redemption because the value of the coupon or card is redeemed for a good or service.

Capital Gains and Losses on Redemptions

The redemption of an investment may generate a capital gain or loss, both of which are recognized on fixed-income investments and mutual fund shares. Taxation of capital gains is reduced by capital losses recognized in the same year. Mutual fund gains and losses are included in the same capital gain calculation.

To compute the capital gain or loss on redemption, the investor must know the cost basis, which is the original value or purchase price of the asset. Bonds can be purchased at a price other than the par or face amount of the bond.

Assume, for example, that an investor buys a $1,000 par value corporate bond at a discounted price of $900 and receives a $1,000 par value when the bond is redeemed at maturity. The investor has a $100 capital gain for the year, and the tax liability for the gain is offset by any capital losses the investor might have. If the same investor purchases a second $1,000 par value corporate bond for $1,050 and the bond is redeemed for $1,000 at maturity, the $50 capital loss reduces the $100 capital gain for tax purposes.

Types of Redemptions

Most redemptions are made for cash. So when a mutual fund investor requests a redemption, the fund management company will issue the investor a check for the shares at market value. But there are cases where redemptions may be made in-kind.

In-Kind Redemptions

In-kind redemptions are non-monetary payments made for securities or other instruments. Rarely used in the mutual fund industry, in-kind redemptions are common with exchange traded funds (ETFs). Fund managers may feel redemptions hurt long-term investors. Therefore, instead of paying out cash to those who wish to exit a fund, they offer positions in other securities on a pro-rata basis.

ETFs are generally considered more tax-friendly than mutual funds. By issuing shares in-kind, the ETF does not have to sell securities to raise cash for redemption payouts. This, in turn, eliminates the need for capital gains distributions, cutting down the investor's tax liability.

Mutual Fund Redemptions

The redemption of fund shares from a mutual fund company must occur within seven days of receiving a request for redemption from the investor. Because mutual funds are priced only once per day, investors who wish to redeem their money must place the order before the market's close or the time set by the mutual fund.

Money is redeemed at the fund's net asset value (NAV) for the day, which is calculated as the sum of the value of the assets of a fund less than its liabilities. Once the sale is completed, clients typically receive their funds including any gains via check or direct deposit to their bank account.

Some mutual funds may have redemption fees attached in the form of a back-end load. A back-end load is a sales charge—a percentage of the fund's value that declines over time. If the investor holds the fund shares for a longer amount of time, the back-end load charged when the shares are redeemed is smaller.

Investments in mutual funds are designed for individuals who buy and hold fund shares for the long term and selling fund shares after a short period of time results in higher costs to the investor. The investor pays sales charges and annual fees for professional portfolio management and the fund's accounting and legal costs.