What Is a Redemption?

The term redemption has different uses in the finance and business world, depending on the context. In finance, redemption describes the repayment of any money market fixed-income security at or before the asset's maturity date. Investors can make redemptions by selling part or all of their investments such as shares, bonds, or mutual funds. In business and marketing, however, consumers often redeem coupons and gift cards for products and services.

Redemptions can trigger capital gains or losses.

Understanding Redemptions

People who invest in fixed-income securities receive regular interest payments at a fixed value. These instruments can be redeemed before or on the maturity date. If redeemed at the time of maturity, an investor receives the par value or the face value of the security.

Corporations that issue bonds or other securities may pay investors a redemption value when they buy back their securities on or before the maturity date. Interest payments generally stop before they do this. The redemption value is typically higher than a bond's par value. So, redemption of these bonds, referred to as called bonds, is at a premium price above par.

For a mutual fund investor to make a 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.

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Redemption

Key Takeaways

  • In finance, redemption describes the repayment of a fixed-income security such as a preferred stock or bond on or before its maturity date. 
  • Mutual fund investors can request redemptions for all or part of their shares.
  • Redemptions may trigger capital gains or losses.

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. 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 $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. If the same investor purchases a $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 payments made for securities or other instruments rather than money—like a swap. 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 to 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 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.