What Is Redemption?
Redemption in the finance and business world can take on multiple meanings depending on the context:
In finance, redemption refers to the repayment of any fixed-income security at or before the asset’s maturity date. Bonds, certificates of deposit (CDs), Treasury notes (T-notes), and preferred shares are common types of fixed-income securities subject to redemption. Another use of the term ‘redemption’ is when coupons and gift cards are exchanged by consumers for products and services.
Key Takeaways
- In finance, redemption describes the repayment of a fixed-income security—such as a Treasury note, certificate of deposit, or bond—on or before its maturity date.
- Mutual fund investors can request redemptions for all or part of their shares from their fund manager.
- Redemptions may trigger capital gains or losses for the investor.
- The investor’s taxation of capital gains will be reduced by any capital losses recognized in the same year.
Understanding Redemptions
Investors in fixed-income securities, such as bonds, receive fixed interest payments at regular intervals. Bonds can be redeemed on or before their maturity date. On maturity, the investor receives the bond’s par value, the agreed-upon repayment amount initially set forth when the bond was issued.
A callable or redeemable bond can be redeemed by the issuer before its stated maturity date. The redemption value is the price at which the issuer repurchases the bond from investors. Issuers may choose to call their bonds if market interest rates decline, facilitating an early payoff of their debt.
Mutual funds are another form of investment that investors can redeem. A mutual fund redemption is initiated by informing the fund manager, who processes the request and releases the funds, usually bringing their value up to the current market price minus any fees.
Consumers redeem coupons or gift cards for goods or services, thereby utilizing another everyday context for the term ‘redemption.’
Capital Gains and Losses on Redemptions
Redemption of investments may result in capital gains or losses, both of which are acknowledged on fixed-income investments and mutual fund shares. Tax liabilities from capital gains can be minimized by offsetting them with capital losses from the same year.
To calculate the capital gain or loss from redemption, an investor must consider the cost basis, which is the original value or purchase price of the investment. For example, if an investor buys a $1,000 corporate bond for $900 and receives $1,000 upon redemption, they realize a $100 capital gain. If there’s a capital loss recognized from a different investment, it can offset this gain for tax purposes.
Types of Redemptions
Most redemptions are processed as cash transactions. A mutual fund investor would typically receive a check or direct deposit for their redeemed shares’ market value. However, in some instances, redemptions may be carried out in-kind.
In-Kind Redemptions
In-kind redemptions involve non-monetary distributions, such as securities. Common in exchange-traded funds (ETFs), in-kind redemptions might be offered to mitigate the adverse impact of redemptions on long-term investments. By providing other securities instead of cash, the ETF can avoid selling securities to produce cash, thereby preventing capital gains distribution and reducing the tax burden on investors.
Mutual Fund Redemptions
Redemption of mutual fund shares must be completed within seven days of receiving the investor’s redemption request. Since mutual funds are only priced once daily, requests should be made before market close or the mutual fund’s designated cut-off time.
The redemption value is based on the fund’s net asset value (NAV) for the day, minus any applicable fees or charges. Once processed, the investor receives their funds via check or direct deposit.
Some mutual funds might impose redemption fees, such as back-end loads, which decrease over time the longer the investor holds onto the shares. These fees incentivize long-term holding and reduce costs associated with short-term transactions.
Investing in mutual funds is generally intended for long-term holding. Investors should be aware of the associated costs, such as sales charges and annual fees, which cover professional portfolio management and other necessary expenses.
Related Terms: Callable Bond, Maturity Date, Mutual Fund, ETF, Capital Gains Tax.
References
- Financial Dictionary. “Redemption”.
- Investor.gov. “Callable or Redeemable Bonds”.
- Investor.gov. “Mutual Funds”.
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
