Non redeemable securities

What Is Non-Redeemable Securities?

Non-redeemable securities are financial instruments that do not have a maturity date or a specific provision for the issuer to repurchase them at a predetermined time. Unlike their redeemable counterparts, investors holding non-redeemable securities generally cannot demand repayment of the principal from the issuer. Instead, these securities typically provide a continuous stream of income to the holder, theoretically in perpetuity, making them a long-term component of a company's capital structure. This category primarily includes certain types of preferred stock and perpetual bonds. While they share characteristics with debt instruments (like fixed coupon payments or dividends), their lack of a maturity date often gives them equity-like qualities.

History and Origin

The concept of non-redeemable financial instruments has historical roots, with perpetual bonds being one of the earliest forms. These instruments allowed entities, often governments or large infrastructure projects, to raise capital without the burden of a repayment schedule for the principal amount. One of the oldest known examples of a perpetual bond was issued on May 15, 1648, by the Water Board of the Dutch city of Lekdijk Bovendams, which was still making coupon payments as of 2015.⁴ Similarly, preferred stock emerged in the mid-19th century in the United States, with the Pennsylvania Railroad Company often cited as issuing the first preferred shares. These shares were designed to offer investors a more stable income through higher dividend payouts and a preferential claim on assets compared to common stock. As financial markets evolved, the non-redeemable characteristic became a feature of specific securities structured to serve long-term financing needs for issuers and provide consistent income streams for investors.

Key Takeaways

• Non-redeemable securities lack a maturity date, meaning the principal amount is not repaid by the issuer.
• They typically offer investors a steady, often fixed, stream of income in the form of dividends (for preferred stock) or interest payments (for perpetual bonds).
• These instruments are considered a permanent part of the issuer's capital, closely resembling equity due to the absence of principal repayment.
• While they provide stable income, their market value can fluctuate with changes in interest rates and the issuer's creditworthiness.
• Non-redeemable securities are often favored by income-seeking investors looking for long-term cash flow.

Formula and Calculation

The valuation of a non-redeemable security, particularly a perpetual bond or a non-redeemable preferred stock, is often calculated as a perpetuity. This formula discounts the infinite stream of future payments back to its present value.

The formula for valuing a non-redeemable security with fixed periodic payments is:

Where:

• (V) = Value of the non-redeemable security
• (C) = The fixed periodic payment (e.g., annual coupon payment for a perpetual bond or annual dividend for preferred stock)
• (r) = The required rate of return or discount rate (reflecting market interest rates and the perceived risk of the security)

For example, if a non-redeemable preferred stock pays an annual dividend of $5 and the required rate of return for similar investments is 6%, its theoretical value would be (V = \frac{$5}{0.06} = $83.33). This calculation assumes that the payments will continue indefinitely.

Interpreting Non-Redeemable Securities

Interpreting non-redeemable securities requires understanding that their value is primarily derived from the stability and consistency of their income stream, rather than any expectation of principal repayment. For an investor, the yield on a non-redeemable security is a key metric. A higher yield might indicate higher perceived credit risk of the issuer or a higher prevailing market interest rate environment. Since the principal is never repaid, the investor's return hinges entirely on these regular payments and the ability to sell the security in the secondary market. Consequently, the interpretation of its market price is heavily influenced by prevailing interest rates; as rates rise, the value of existing non-redeemable securities with fixed payments typically falls, and vice versa. This makes them particularly sensitive to interest rate risk.

Hypothetical Example

Consider a hypothetical company, "Everlast Corp.," which issues non-redeemable preferred stock. Each share has a par value of $100 and promises a fixed annual dividend of $7. Investor A purchases 100 shares of this non-redeemable preferred stock.

1. Initial Investment: Investor A pays $100 per share for 100 shares, totaling an initial investment of $10,000.
2. Annual Income: Each year, Investor A receives a dividend of $7 per share, amounting to $700 annually ($7 x 100 shares).
3. No Maturity: Everlast Corp. is not obligated to repurchase these shares, meaning Investor A will continue to receive $700 annually as long as the company remains solvent and pays its preferred dividends.
4. Market Value Fluctuation: Five years later, market interest rates increase significantly. New preferred stocks with similar risk profiles are now offering an 8% dividend yield. The market price of Everlast Corp.'s non-redeemable preferred stock would likely decrease to reflect this higher prevailing rate, as investors would demand a similar yield for the fixed $7 dividend. If Investor A decided to sell, the shares might fetch less than the initial $100 per share, demonstrating the liquidity risk and interest rate sensitivity.

Practical Applications

Non-redeemable securities are employed in various financial contexts, serving both issuers and investors. For corporations and governments, they offer a means of securing permanent capital without the burden of principal repayment, effectively functioning as a form of perpetual financing. This is particularly useful for entities with long-term projects or consistent capital needs. Financial institutions, especially banks, often issue perpetual bonds or preferred stock as a way to raise regulatory capital (e.g., Tier 1 capital), as these instruments are considered highly stable due to their non-redeemable nature.

For investors, non-redeemable preferred stock and perpetual bonds are attractive for generating a stable, predictable income stream, making them suitable for portfolios focused on consistent cash flow, such as those of retirees or institutional investors with long-term liabilities. For instance, non-redeemable preferred stock is defined as preferred stock not required to be redeemed at any fixed date or at the option of the holder.³ They are often found in the portfolios of income-focused investment funds. Furthermore, their position in the capital stack typically grants them preference over common stockholders in dividend payments and claims on assets in the event of liquidation, offering a layer of safety compared to common equity.²

Limitations and Criticisms

While non-redeemable securities offer benefits, they also come with significant limitations and criticisms. The primary drawback for investors is the lack of principal repayment. Unlike a traditional fixed-income security that returns the principal at maturity, the investor in a non-redeemable security must sell it in the secondary market to recover their initial investment. This exposes them to market price fluctuations, which can be substantial, particularly in response to changes in interest rates.

Another key criticism is the inherent interest rate risk. As interest rates rise, the fixed payments from existing non-redeemable securities become less attractive compared to new issues, causing their market value to decline. Conversely, falling interest rates can make them more valuable. Additionally, investors face credit risk, as the ability of the issuer to make perpetual payments depends on its ongoing financial health. Deterioration in the issuer's credit quality can lead to a fall in the security's market price or even a suspension of payments. For preferred stocks, dividend payments are not guaranteed and can be suspended if the company faces financial difficulties, though cumulative preferred stock may accrue these unpaid dividends. Periods of economic downturn or financial instability can significantly impact preferred stock performance, demonstrating the inherent credit risk.¹

Non-redeemable securities vs. Redeemable securities

The key distinction between non-redeemable securities and redeemable securities lies in their maturity and repayment features.

Non-redeemable securities, also known as irredeemable debentures or perpetuals, offer a permanent source of capital for the issuer. Redeemable securities, on the other hand, provide a temporary source of financing that must be repaid. The choice between these two types of securities depends on the issuer's financing needs and the investor's risk tolerance and income objectives.

FAQs

What is the main characteristic of a non-redeemable security?

The main characteristic of a non-redeemable security is that it has no fixed maturity date, meaning the issuer is not obligated to repay the principal amount to the investor. Instead, it provides ongoing payments, such as interest or dividends.

Are non-redeemable securities riskier than redeemable ones?

In some ways, non-redeemable securities can be considered riskier due to the absence of principal repayment. Investors bear the full market risk if they need to sell before the issuer calls the security (if a call feature exists), as its market value can fluctuate significantly with changes in interest rates or the issuer's financial health. They also carry liquidity risk if there isn't an active secondary market.

Do non-redeemable securities pay interest?

Yes, non-redeemable securities typically pay regular income to investors. For perpetual bonds, these are called coupon payments, similar to traditional bonds. For non-redeemable preferred stock, these payments are in the form of fixed dividends.

Can a non-redeemable security ever be repurchased by the issuer?

While non-redeemable securities do not require the issuer to repurchase them, some may include a "call" provision. This provision gives the issuer the option to buy back the security after a certain date or under specific conditions, often at a predetermined price. This is common with many modern preferred stocks and perpetual bonds, allowing issuers flexibility to refinance at lower rates if market conditions become favorable.

Are non-redeemable securities common today?

Yes, non-redeemable securities, particularly in the form of perpetual bonds and certain types of preferred stock, are still issued today, especially by financial institutions and large corporations. They are a way for these entities to raise permanent capital and can be attractive to investors seeking consistent income streams.