An effective portfolio mix includes a combination of equity and debt instruments. In India, the debt market is in its nascent stage. However, it offers various types of products such as fixed and floating rate bonds, zero coupon bonds, perpetual bonds, corporate deposits, commercial paper, treasury bills, and many more. Instruments such as perpetual bonds offer attractive returns with relatively low risk.
What are Perpetual Bonds?
Perpetual bonds, or “perps”, are bonds with no maturity date. While perpetual bonds pay interest like other bonds, the issuer does not repay the principal amount on maturity. In other words, perpetual bonds pay interest till eternity.
Many investors consider perpetual bonds a type of equity instrument rather than debt. One major disadvantage of a perpetual bond is it is non-redeemable. Conversely, it pays a fixed, recurring income at regular intervals forever.
In India, some perpetual bonds have a call option. The issuer can exercise the call option, allowing the investor to sell the bonds to the issuer. Typically, call option dates are every five or ten years from the bond issue date. Alternatively, perpetual bonds trade on listed stock exchanges, and one can sell the bonds for liquidity or in case of an emergency.
Even though perpetual bonds pay interest forever, you can assign a finite value to the bond that represents its price. The price of a perpetual bond is the fixed interest or coupon payment divided by a constant discount rate. The constant discount rate represents the time value of money. The discount rate denominator decreases the absolute value of the fixed coupon payment over time, eventually reducing it to zero.
Understanding Perpetual Bonds
Perpetual bonds definition is niche and introduces them as uncomplicated debt instruments. The issuer uses perpetual bonds to raise capital at fixed interest or coupon rates, whereas investors constantly purchase perpetual bonds to receive a fixed income. The issuer is not obligated to repay the principal unless the issuer chooses to redeem the bond and exercise the call option.
For an investor, perpetual bonds are relatively safe since the interest or coupon payment is lucrative and predetermined. Simultaneously, perpetual bonds are subject to credit risk or default risk.
Additionally, perpetual bonds are also subject to interest rate risk. Interest rates in a free market are dynamic and dependent on multiple factors. The investment value of perpetual bonds may reduce if the interest rate in the free market is more than the bond's coupon rate.
Perpetual bonds closely resemble equity instruments that pay consistent dividends. The perpetual bonds meaning is a debt obligation. The issuer need not repay the principal amount till bondholders regularly receive interest payments. Contrarily, the dividend amount paid to shareholders varies based on the company's performance. Also, a perpetual bond does not carry any voting rights in the entity's decision-making.
Do the Coupon Payments Go on Forever?
Most investors wonder if the coupon payments go on forever in case of non-redemption. The brief response is 'Yes'. For example, the Water Board of a Dutch city issued perpetual bonds in 1648, and the holders continued to receive payments as of 2015.
The most salient feature of a perpetual bond is that the issuer has no obligation to return the principal amount to the investor. In practice, most perpetual bonds have an option to call or redeem the bond at any time after a certain period. For example, five years from the date of issue of bonds. Therefore, some issuers may eventually redeem the bonds.
Perpetual bonds are not subject to a fixed redemption date. The time for redemption is open and at the issuer's reference. Most issuers wait till they can most easily afford the bonds. Therefore, perpetual bonds not only offer a right but an obligation to the issuer for bond redemption.
For example, issuers may redeem the bond if the bond's coupon rate exceeds the general borrowing cost. Some issuers use perpetual bonds to avoid refinance costs associated with bonds with fixed maturity dates.
Who Issues Perpetual Bonds?
The share of perpetual bonds in the overall bond market is relatively small. Government entities and banks primarily issue perpetual bonds.
Banks use perpetual bonds to meet their long-term capital requirements. For banks, perpetual bonds are Additional Tier I instruments with quasi-equity features. In case of liquidation, perpetual bondholders appear before equity shareholders in the sequence for payment. Also, the current year's coupon payment of perpetual bonds depends on the bank's profitability. If the bank is loss-making or fails to meet the minimum adequacy requirement by the government, then it has the option to not pay interest for the financial year.
Some economists consider perpetual bonds an ideal instrument to raise capital for financially stressed governments. Conversely, conventional economists are against the government raising debt without any obligation to repay. Governments view contractual payments perpetually as a hindrance to a sound fiscal policy.
The Appeal for Investors
Perpetual bond is an attractive investment avenue for the following reasons:
● Periodic Income
Perpetual bonds are ideal for investors who wish to secure a regular fixed income that will continue indefinitely. Generally, retired investors prefer perpetual bonds to ensure a fixed income source for a long time.
● Risk Involved
Perpetual bonds are safe instruments and not subject to market risks. Therefore, perpetual bonds are suitable for risk-averse investors. However, investors must analyse the issuer's creditworthiness and financial stability before investing.
● Bond Yield
Issuers offer higher interest rates on perpetual bonds than bonds with fixed maturity dates to compensate for the lack of a fixed redemption obligation. In India, the yield on perpetual bonds is 200-300 basis points higher than government bond yields.
● Interest Rate Risk
Issuers may offer a fixed schedule with a step-up feature to periodically improve the coupon rate. For example, the interest rate of the bond increases by a fixed percentage once in 10 or 15 years.
Some issuers also offer perpetual bonds at a floating interest rate instead of a fixed interest rate. The issuer may link the coupon rate to a benchmark interest rate, such as the prevailing yield for government securities or the London Interbank Offer Rate.
● Reinvestment Risk
Perpetual bonds are not subject to reinvestment risk. You can avoid the time and effort required to find a suitable alternative when the perpetual bond matures. An investor must analyse the risks associated with perpetual bonds in tandem with investment objectives to ascertain investment feasibility.
Calculating the Yield on a Perpetual Bond
One of the most significant factors for consideration is the return on investment. The current yield on a perpetual bond is a function of the periodic coupon payments and the fair market value of the bond.
Investors can calculate the yield on a perpetual bond as below:
(Periodic Coupon Payment/Market Price of the Bond) * 100
For example, the face value of a perpetual bond is Rs. 1000, whereas its purchase price is Rs. 900. The bond pays an annual interest of 7% per annum. Therefore, you will receive a coupon of Rs. 70 (Rs. 1000 * 7%) per year.
The bond's current yield is [(70/950) *100], i.e., 7.36%.
Irrespective of the risk associated with perpetual bonds, it is a suitable alternative for some investors. Before investing, you must thoroughly comprehend the risk and reward trade-off.