Companies raise financing through two sources mainly, Equity and Debt. Some financing instruments have hybrid nature of equity and debt financing such as preferred stocks. Debt can be defined in several ways depending on the characteristics and nature of the financing. One way of defining debt is the redemption or repayment terms.
A Redeemable Debt can be called or redeemed by the issuer before the maturity date. The redemption of the debt may take different forms as per the contract. However, mostly it depends on the issuer’s discretion to call the debt and repay the investor with the face value of the debt.
Redeemable bonds, CDS, debentures, and some preferred stocks are common types of Redeemable debt instruments. Issuers use the redeemable debt to raise capital for long-term financing needs. As these debts come with a redemption clause, investors consider it a risky investment. For risk compensation, the issuers usually offer higher interest rates on callable or redeemable debt than irredeemable debts.
How Redeemable Debt Works?
Redeemable debts often benefit both issuers and investors. Issuers raise capital financing, and issuers invest in slightly higher interest rate instruments. Large financial institutes often issue corporate bonds with redemption clauses.
A redeemable debt, usually bonds or debentures, comes with a call option for the issuers. To compensate for the risk, issuers call the debt at a premium than face value. The interest rate or coupon paid on these debts is usually also higher than the market interest rate for irredeemable debts.
Let us say, a company Techno Green issues a redeemable bond with a maturity date of 20 years, face value of $100, and an interest rate of 7%. The bond comes with a redemption clause and the issuer may redeem it after five years.
If the interest rates fall below 7% in five years from now, say 4%, the bond issuer will consider issuing a new bond with a lower interest rate. Continuing with the old high-interest rate bond would increase the finance costs for the issuer. The investors would require some compensation to forego their investment returns. The issuer may call the bond at a premium, say $ 105 and repay the investors the accrued interest to that date.
Investors in most cases make the reinvestments with newer bonds, as they see similar interest rate returns in the market. In a way, the redemption of debts favors both the investor and the issuer.
Types of Redemption Clauses
Investors know the fact of the redemption clause attached to the redeemable debt. These redemption clauses can take three different forms.
Mandatory Redemption: The debt instrument will be redeemed on a predetermined date. Many bonds and some preferred stocks are issued with a mandatory redemption clause.
Optional Redemption: The issuer keeps the option of calling the debt back. Usually, the contract determines a minimum period after which the redemption clause becomes effective.
Sinking Fund or Contributable Redemption: The issuer contributes a portion of repayment to the sinking fund that is used to make the repayment at the redemption date.
Sinking funds come with partial redemption contracts. The contribution is one form of securing the repayment of the debt to the investors. These sinking funds can also be used with mandatory redemptions that come with time or amount term in the contract.
Consideration with Redeemable Debts
The obvious risk with debt instruments comes with changes in the interest rates. Interest rate risks make debts split into variable and fixed interest rate instruments. Bonds and debentures come with an inverse relationship with interest rates. For both investors and issuers, the change in interest rate affects their benefits and returns.
Redeemable debts pose a reinvestment risk for investors. Once the interest rates fall below the bond or debt rates, investors are left with fewer options to consider.
Investors keep the redemption clause to take advantage of lower future interest rates. Additionally, the investors would be able to save on interest by repaying the debt in full before maturity.
Practically, for large debt instruments, the redemptions work more like refinancing contracts. The issuers of debt instruments like bonds compensate investors with a premium on face value. Also, the investors may redeem a partial amount and keep the remaining investment. The investors usually issue new bonds with new interest rates to the same investors.
Redeemable Vs Irredeemable Debt
Irredeemable or perpetual debts are in rarity. The Equity form financing and long-term debts make newer hybrid financing instruments that can be termed as both equity and debt. Preferred shares and irredeemable debt are common examples of having features of both equity and debt.
Irredeemable or Perpetual debt is the one that does not come with a maturity date. The investors receive a coupon or interest payment for perpetuity without principal repayment. The coupon or interest rate is predetermined at issuing the debt. The issuers without a special clause cannot redeem the debt from the investors. For the feature of irredeemable nature, such debt is often classified as equity under the company balance sheet than long-term debts.
Issuers have the option of calling the redeemable debt before the maturity date. The issuers can redeem the debt in full or partially with the attached redemption clause in the contract. The investors receive the coupon and the principal repayment on redemption.
Advantages of Redeemable Debt
When interest rates fall below the redeemable debt rates (bond coupon), issuers look for cheaper financing options. The redeemable clause protects the issuers against the interest rate risk. Investors are practically left with little choice but to reinvest in the new bonds with lower interest rates.
Redeemable debt offers some benefits to both issuers and investors:
- Pays fixed coupon to the investors for the life of debt or until the debt is redeemed.
- Investors consider it a secured investing option with repayment terms.
- Issuers can raise large finance for the company.
- A redeemable clause can secure the issuers against the interest rate risks.
- Investors are usually protected from interest rate risk too unless the issuer redeems due to a significant fall in the interest rates.
Disadvantages of Redeemable Debt
The redeemable feature of the debt protects the investors against the default risk. However, many implications still make investments in debt instruments risky. Some of the disadvantages of redeemable debt instruments include:
- Redeemable debt often comes with lower interest rates, although higher than irredeemable or unsecured debts.
- Investors face the reinvestment risk with redemption.
- Investors cannot take advantage of higher interest rates with existing debts.
- Issuers may have to incur higher costs with redeemable debts such as offering premium value at redemption.
Redeemable debts pay lower but fixed interest rates to the investors. Issuers are protected against the falling interest rate risks with a redemption clause. The repayment clause also makes investment security for investors.