Redemption Premium: Detailed Definition
What is a Redemption Premium?
The redemption premium (or call premium) refers to the additional amount over and above the bond’s par value that the issuer must pay to bondholders if the bond is called or redeemed before its maturity date. This premium serves as compensation to investors for the potential loss of interest income that has been curtailed due to early redemption.
Examples of Redemption Premiums
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Corporate Bonds: A corporation issues bonds with a par value of $1,000, stipulating a redemption premium of $50 if the bonds are redeemed within the first five years. If the company decides to redeem the bonds after three years, it must pay a total of $1,050 per bond ($1,000 par value + $50 premium).
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Municipal Bonds: A municipality issues bonds with a par value of $500 and includes a redemption premium of $20. If market interest rates fall, making it attractive for the city to refinance the debt at a lower rate, it may call the bonds and pay $520 per bond ($500 par value + $20 premium).
Frequently Asked Questions (FAQs)
Q1: Why do issuers include a redemption premium in bond agreements?
A1: Issuers include a redemption premium to compensate investors for the interest income they forfeit due to the bonds’ early redemption. This makes the bonds more attractive to investors.
Q2: How is the redemption premium calculated?
A2: The redemption premium is typically specified in the bond’s indenture as a fixed dollar amount or a percentage of the par value.
Q3: Can all types of bonds have a redemption premium?
A3: Not all bonds come with a redemption premium. It is most common in callable bonds, which grant the issuer the option to redeem them before the maturity date.
Q4: Is the redemption premium always the same throughout the bond’s life?
A4: No, the redemption premium can decrease over time according to the schedule specified in the bond’s indenture.
Q5: How does a redemption premium protect investors?
A5: It compensates investors for the potential loss of future interest payments, thus mitigating some of the risks associated with early bond redemption.
Related Terms
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Callable Bond: A bond that can be redeemed by the issuer before its maturity date at a specified call price.
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Par Value: The face value of a bond, which is paid to the bondholder upon maturity.
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Yield to Call: A yield calculation intended for callable bonds, which estimates the rate of return if the bond is called before its maturity date.
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Call Date: The date on which a bond can be redeemed before its maturity.
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Indenture: A formal agreement, often a legal document, that specifies the terms of the bond issuance, including call provisions and redemption premiums.
Online References and Resources
Suggested Books for Further Studies
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“The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau
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“Investment Analysis and Portfolio Management” by Frank K. Reilly and Keith C. Brown
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“Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
Accounting Basics: “Redemption Premium” Fundamentals Quiz
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