Question

The importance of knowing the terms of bond issues, especially those relating to redemption, cannot be overemphasized. Yet there have appeared numerous instances of investors, professional and others, who acknowledge that they don’t read the documentation. For example, in an article published in the New York Times, the following statements were attributed to some stockbrokers: “But brokers in the field say they often don’t spend much time reading these [official] statements,” “I can be honest and say I never look at the prospectus. . . . Generally, you don’t have time to do that,” and “There are some clients who really don’t know what they buy. . . . They just say, ‘That’s a good interest rate.’” Why is it important to understand the redemption features of a bond issue?

Answer 1

Redemption feature of the bond allows the issuer of the bond to recall or payoff the bond principle and accrued interest to the bond holder before maturity date and stop making any further payments. For example, if you had purchase a callable bond having maturity of 10 years. But, a callable bond has redemption feature. That means, it can recall and close this bond by paying you off before the maturity date.

Companies generally do this when they realize that the market interest rate is lower than what they are paying as coupon rate to you. In case the market interest rate is 4% and the bond is paying you 4.5%, it is a loss to the company. In this scenario, the company can recall this bond and reissue a new bond at 4% thereby saving 0.5% of interest payment.

However, such a move is disadvantageous to the investors who have not understood or read the redemption feature of their bond as suddenly they find their bond being recalled and closed. Now, they have to purchase a new bond at a lower rate which they had not anticipated.