Redeemable Debt
Redeemable Debt is the debt that the issuer can pay off before the maturity date, it is also known as callable debt.
Debt is the amount of cash that businesses borrow from the bank or creditors. The company borrows cash to support operations, expand the business, construct new fixed assets, and so on. It is the way that company can raise capital without scarified the ownership of company such as shares. But the debt will come with a cost which is the interest and the payback date. Failing to comply with the debt’s terms will result in a dangerous situation such as liquidation.
There are many types of debt that a company can raise such as bank loans, bonds, debenture, Line of credit… etc. These kinds of debt require the borrower to pay back both principal and interest based on the schedule. Both parties must comply with the terms and conditions of the debt. After issuing debt to the market, they will pay interest based on the schedule and coupon rate. The principal will be paid on the maturity date stated on the bond/debt.
The term in the debt protects both parties by following the agreed schedule which is made in the early day. The borrower may not have enough cash flow to pay if the creditor requires to pay back the loan prior to the schedule. On the other hand, if the borrower ends the loan before schedule, the creditor needs to look for the opportunity to invest the loan in other places. To prevent such an issue, the borrower and creditor require to follow the payment schedule unless both of them agree.
However, the redeemable debt will allow the issuer to recall the bond before its maturity date. The debt issuer (borrower) has the option to pay off the debt before the maturity date. It is highly likely to happen when the market rate decrease below the debt’s interest rate.
The bondholders (creditors) will need to find other investments when the borrower pay back beforehand. They may lose some return during the transfer of investment to the other companies. The bondholder will receive the premium fee in exchange for the early redemption.
The redeemable debt allows the option for borrower to pay off before the majority date. It can save them some cost if the market rate falls below the current interest rate, but they need to pay the premium to the creditors. Management must compare to ensure the cost saving is higher than the premium paid.
Redeemable Debt Example
Company ABC issues 100,000 redeemable bonds at a par value of $ 1,000 and a coupon rate of 8%. The bonds will be mature in 10 years. However, the issuer has the option to call or redeem the bond before the maturity date.
At the end of 3rd year, the market interest rate drops to 5%. It means the issuer can issue new bonds at lower than 8%. They can save 3% on the cost of debt. So the company can redeem the 8% bonds and issue new bonds at a lower rate.
Reasons for Debt Redemption
Bonds market price has a direct connection with the market interest rate. As we know, the interest rate on bonds is fixed, however, the interest rate in the market is fluctuating. When the market interest rate rises above the bond’s rate, investors will sell the bond and move their cash to higher-return investment. It will cause the bond market price to drop as the supply more than the demand.
On the other hand, the price will increase when the interest rate in the market drop below the coupon rate. Investors will be looking to buy the bond as it generates higher returns compared to the market. It means that the issuer is paying higher interest to the bondholders. So they will try to redeem the debt and save the cost by seeking other sources of fund which has a lower rate.
In other cases, the issuer may have surplus cash that remains after the investment. Management will use the cash to pay off some debt rather than letting them sit in the bank for nothing. Redeemable debt will allow the company to pay off debt and save the cost of capital before it reaches the maturity date.
Advantage of Redeemable Debt
- Allow the issuer to redeem and save cost of Debt: This type of debt allows the issuers to recall the debt when its cost is higher than the market. So they will be able to save cost of capital.
- Receive premium fee: Investors will receive a premium fee when the issuer recalls the bond.
- Be able to control the debt: The issuer will be able to control amount of debt and gearing ratio. They will simply recall the debt when they want to change the gearing ratio.
Disadvantage of Redeemable Debt
- Risk for investors: Investors will face risk when interest rates fall as the issuers are highly likely to redeem the bond. So investors will need to find a new investment that may have a lower rate of return.
- High Cost for issuer: Due to the risk for investors, the issuer needs to increase the coupon rate to convince the investors to buy the bond.