Mandatory Redemption Schedule (Bond) - Explained
What is a Mandatory Redemption Schedule?
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Table of ContentsWhat is a Mandatory Redemption Schedule?How Does a Mandatory Redemption Schedule Work?
What is a Mandatory Redemption Schedule?
The mandatory redemption schedule is a plan that specifies the point at which the issuer of a bond with a sinking fund provision is required to redeem all or part of the outstanding issues of the particular bond prior to its maturity and in accordance with the call or prepayment conditions of the original bond contract. In other words, the mandatory redemption schedule requires the bond issuer to set aside funds for the repayment of the bond at maturity, thus reducing the risk of default. Mandatory redemptions may either occur according to a schedule or subject to the availability of a specified amount of money in the sinking fund.
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How Does a Mandatory Redemption Schedule Work?
Redemption schedules are broadly classified into two types (1) Mandatory redemption schedules, and (2) Optional redemption schedules. The mandatory redemption schedule decrees that bonds be redeemed via a call provision at a specified price, usually at par (known as a par call) or at accreted value (known as a premium call), with the bondholder receiving any accrued interest up to the date of redemption. This date of redemption always precedes the stated maturity date of the bonds. On the other hand, an optional redemption schedule bestows upon the issuer the option to buy back the bonds from investors on dates specified in the trust indenture of the bond. Bond issuers can exercise optional redemptions only on or after a specified date, usually beginning approximately ten years after the date of issue. It should be noted here that all term bonds have their own sets of mandatory redemption schedules specified in the original bond agreements. The most important utility of a mandatory redemption schedule is to manage cash flows for mandatory calls. Several types of mandatory redemptions occur on the basis of a schedule, or are triggered by the availability of a specified amount of money in the sinking fund (also referred to as sinking fund redemptions). A sinking fund is a type of separate custodial account formed by the issuer in order to make periodic deposits in order to pay for the costs of calling bonds in conformity with the conditions mentioned in the mandatory redemption schedule. A mandatory redemption can either be made in full or in part before the date of maturity. A partial redemption will result in the bonds being selected for redemption in either of the following three ways:
- By lot, in either maturity or inverse maturity order.
- By a strip call, i.e. a process engineered to maintain a favorable debt service payment characteristic with respect to the outstanding bonds.
- By selection at the discretion of the issuer or conduit borrower.
Moreover, a mandatory redemption is often triggered by unusual circumstances that threaten to affect the source of revenue used by the issuer to service the debt. Let us consider the following example to better illustrate this scenario. Suppose, the Federal Aviation Administration (FAA) decides to issue a revenue bond to fund a new airport. The FAA thus earmarks a part of the revenue generated from airport fees and taxes to service the debt. However, the occurrence of a severe hurricane has destroyed part of the airport, rendering it inoperable. This will directly impact cash flow into the business, rendering the issuer unable to continue servicing the debt. The FAA will then trigger the extraordinary redemption clause, that allows it to call its bonds due to an adverse one-time occurrence.