Redemption of a Bond

Redemption of a bond is the issuer paying the holder the bond’s redemption price, the amount the bond’s own terms fix for retiring it, and taking the debt off its books. It happens at maturity, when the issuer pays the amount the schedule always said it would pay, or before maturity under redemption terms written into the contract the bonds were issued under, meaning a call or a mandatory sinking fund redemption. An issuer can also retire bonds early by buying them back through a tender offer or in the open market, which extinguishes the debt through a market transaction rather than through a redemption right written into the contract. However the debt is retired, the liability comes off the issuer’s books, and the difference between what the issuer pays to get the bonds back and what the debt was carried at becomes a gain or a loss in that period.

The Routes a Redemption Can Take

Bond lawyers in the municipal market group the routes three ways. An optional redemption gives the issuer the right to retire all or part of the bonds before their maturity dates. A mandatory sinking fund redemption applies to term bonds and requires the issuer to retire a specific amount of the outstanding principal by redemption on specific dates. An extraordinary mandatory redemption is triggered by certain unexpected or one-time events affecting the bonds or the project financed with the proceeds (National Association of Bond Lawyers, Bond Basics, Redemption).

Two mechanics follow from that. Whenever bonds are to be redeemed a notice must be published or mailed to bondholders, with the contents, timing and delivery method fixed in the bond form and the indenture, and the issuer may have to pay a premium in order to redeem, where typically the earlier the bonds are redeemed the higher the premium (National Association of Bond Lawyers, Bond Basics, Redemption). The contract those provisions live in is covered in indenture, and the call price and call premium a holder receives sit in face amount of a bond.

What the Issuer Records at Retirement

Two defined amounts decide the size of the gain or loss. The net carrying amount of debt is the amount due at maturity, adjusted for unamortized premium, discount, and cost of issuance. The reacquisition price of debt is the amount paid on extinguishment, including a call premium and miscellaneous costs of reacquisition, and where extinguishment is achieved by a direct exchange of new securities it is the total present value of those new securities (APB Opinion No. 26, paragraph 3).

The rule that puts the two together is short. A difference between the reacquisition price and the net carrying amount of the extinguished debt should be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item, and gains and losses should not be amortized to future periods (APB Opinion No. 26, paragraph 20). How the debt was retired does not change that, because all extinguishments of debt are fundamentally alike and the accounting should be the same regardless of the means used to achieve it (APB Opinion No. 26, paragraph 19).

For a preparer, redemption is where every deferred piece of the borrowing finally clears. Unamortized discount or premium and unamortized issuance costs are inside the net carrying amount by definition, so whatever is left of them at the redemption date gets absorbed into the gain or loss instead of continuing to run through interest expense. How that carrying amount got where it is, and the effective interest method that moved it, is worked through in bonds payable.

A Worked Example

Say an issuer calls a bond issue partway through its term and pays some trustee and agent costs to get it done. The call price comes out of the indenture and the rest comes off the debt schedule.

Face amount                                      300,000
Unamortized discount                               6,400
Unamortized issuance costs                         2,100
Net carrying amount    300,000 - 6,400 - 2,100 =  291,500

Call price, 103% of face                          309,000
Costs of reacquisition                              1,500
Reacquisition price    309,000 + 1,500         =  310,500

Difference             310,500 - 291,500       =   19,000  loss

The loss is bigger than the call premium alone, because the unamortized discount and issuance costs had to clear at the same time and the trustee and agent costs went into the reacquisition price.

A Redemption Gain or Loss Is Not an Extraordinary Item

Older material still classifies a redemption gain or loss as extraordinary, and two changes removed the basis for that. FASB Statement No. 145 rescinded FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, which had required those gains and losses to be aggregated and, if material, classified as an extraordinary item, and the rescission applies in fiscal years beginning after May 15, 2002 (FASB Statement No. 145, paragraphs 1, 6 and 10). Then the category itself went, because the concept of extraordinary items was eliminated from GAAP (FASB Accounting Standards Update 2015-01). A redemption gain or loss is now an ordinary income statement item, identified as a separate item rather than classified as extraordinary, so a client carrying an old presentation is worth a look on a first-year engagement.

What Changes on the Return

The tax side starts from the opposite premise to the book side. An issuer does not realize gain or loss upon the repurchase of a debt instrument, and for that purpose repurchase includes the retirement of a debt instrument, its conversion into stock of the issuer, and the exchange of a newly issued debt instrument for an existing one (Treasury Regulation 1.61-12(c)(2)(i)).

What the issuer gets instead turns on which side of adjusted issue price the payment lands. Adjusted issue price is the issue price of the instrument, increased by original issue discount (OID) previously includible in the gross income of any holder and decreased by any payment previously made other than a payment of qualified stated interest (Treasury Regulation 1.1275-1(b)(1)). A repurchase below it produces discharge of indebtedness income equal to the excess of the adjusted issue price over the repurchase price (Treasury Regulation 1.61-12(c)(2)(ii)). A repurchase above it produces repurchase premium, and except to the extent another Code section disallows the deduction, section 249 being the one the regulation names, that excess is deductible as interest for the taxable year in which the repurchase occurs, unless the repurchase is a debt-for-debt exchange whose new issue price is determined under section 1273(b)(4) or section 1274, in which case the premium is amortized over the term of the new instrument in the same manner as if it were OID (Treasury Regulation 1.163-7(c)).

That is why a mid-year redemption rarely ties out on its own. The book figure is measured against net carrying amount and the tax figure is measured against adjusted issue price, and cost of issuance is named in the first definition and absent from the second, so the loss on the trial balance and the interest deduction on the return are usually two different numbers describing one transaction.

What the Holder Sees at Redemption

For broker reporting, the retirement is a sale. The term sale means any disposition of securities and includes retirements of debt instruments, including a partial retirement attributable to a principal payment received on or after January 1, 2014, but only to the extent conducted for cash (Treasury Regulation 1.6045-1(a)(9)(i)). A redeemed bond sitting in a brokerage account therefore tends to arrive on Form 1099-B rather than passing unreported, and what the proceeds figure on that form has already had taken out of it is set out in proceeds.

Savings bonds run on a different clock. Where the holder has not elected to include the increase in redemption price currently and no section 1037 exchange applies, the taxpayer treats the increase as income for the year in which the obligation is redeemed or disposed of, or finally matures, whichever is earlier (Treasury Regulation 1.454-1(a)(1)). The form follows the cashing rather than the accrual. If a bank cashes the bond the bank is responsible for getting the holder a 1099-INT, and where Treasury cashes a paper bond it mails the 1099-INT the following January (TreasuryDirect, Cash EE or I savings bonds). Which box on that form carries what, and the payer’s filing floors, are in interest income, and interest running between payment dates on a coupon bond is in accrued interest.

What Redemption Is Not

It is not the stated redemption price at maturity. That phrase names a measurement input for original issue discount rather than an event, the sum of all payments the instrument provides other than qualified stated interest (Treasury Regulation 1.1273-1(b)), and how it sits against par is covered in face amount of a bond. Redemption is the payment itself.

Redemption at maturity is also not the same event as a call. At maturity the issuer pays what the schedule always said it would pay, and if amortization ran its course there is normally nothing left of the discount, premium or issuance costs to clear, so the difference recognized in income is normally zero. A call is early and priced by the indenture, so the reacquisition price can carry a call premium the maturity payment never would, and the unamortized balances are still sitting there to absorb.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can run a block of its own debt retirement entries and book-to-tax reconciliations through a trial task before anything client facing depends on it.