Partial Redemption

What Is Partial Redemption?

A partial redemption is the retirement or payment of a portion of a callable (or redeemable) security before its maturity date. Call (or prepayment) provisions govern how early redemptions, whether whole or partial, are handled. Issues may utilize a a redemption schedule that spells out the partial redemption over time, which can be found in the prospectus.

Key Takeaways

  • A partial redemption involves redeeming (calling in) some amount of issue before it matures.
  • Unlike a whole redemption, the partial redemption redeems only a certain proportion of the issue at a time.
  • Redemption schedules can inform investors the threshold or triggers that will cause the issuer to call in some of an issue.

Partial Redemption Explained

Callable bonds are typical of corporate and municipal issuers who wish to have the option to pay off their debt if interest rates drop below the rates on their outstanding bonds. Redeeming the bonds and issuing new bonds at lower rates will save money on interest expenses. In exchange for the possibility that the bond could get called away, the bond investor will receive a slightly higher interest rate compared to a similar non-callable bond.

When an issuer calls its bonds, investors receive the call price and any accrued interest to date. The bonds are often called at par value, but sometimes they are called at a premium to par. The call premium is another form of compensation to the investor who now must reinvest in a lower interest rate environment.

Some issues have mandatory redemption schedules, which are useful for managing cash flows for investors of callable securities. Some types of mandatory redemptions occur either on a scheduled basis, or when a specified amount of money is available in the sinking fund. The sinking fund is the annual reserve in which an issuer is required to make periodic deposits that will be used to pay the costs of calling bonds in accordance with the mandatory redemption schedule in the bond contract or to purchase bonds in the open market. A mandatory redemption schedule may require the issuer to redeem 70% of bonds ten years from the issue date, for example.

Partial Redemption Process

In general, bond investors want to keep their higher-yielding bonds when interest rates decline. When their bonds are called, they expect to be treated fairly and not singled out to give them up. According to Financial Industry Regulatory Authority (FINRA) Rule 4340, a financial institution that controls callable bonds on behalf of clients must establish and make available on its website procedures by which it will allocate among its customers, on a fair and impartial basis, the securities to be redeemed or selected as called in the event of a partial redemption.

Furthermore, if the redemption is favorable (call price above the current price of the bond), no affiliated party of the financial institution can be included in the allocation pool until all clients' positions have been satisfied. If the redemption is unfavorable, no affiliated party can be excluded from the pool. Though not mandated by FINRA, a lottery process is the preferred method for allocation, as it is considered fair and impartial.

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