What Is a Redemption?

The term redemptions has many different uses in the financial and business worlds. It all depends on the context on how the term is being used, and in reference to the instrument applied.

In finance, it is used to describe the repayment of any fixed-income security such as a preferred stock or bond at or before the asset's maturity date. Investors can make redemptions by selling part of all their investments, such as shares of their mutual funds. In business and marketing, however, consumers can 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 get regular interest payments at a fixed value. These instruments can be redeemed before or on the maturity date. 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.

In order for a mutual fund investor to make a redemption, he must inform his fund manager of his request. The manager must process the request within a certain amount of time and distribute the funds to the investor, which is normally the current market value of their shares—less any fees and other charges.

As consumers, we often make redemptions during the course of our everyday lives. If you've ever used a coupon or a gift card, you are redeeming its value for a good or service. So if a friend gives you a $50 gift card for a department store, you can redeem it for merchandise up to its limit at that retailer.



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 needs to 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.

Key Takeaways

  • The term redemption has many different uses, depending on the context in which it is used.
  • In finance, it 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.

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 goes through, 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 place of a back-end load. A back-end load is a sales charge—a percentage of the fund's value which 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.

In-Kind Redemptions

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

In-kind redemptions are payments made in 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, so 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 doesn't 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.