The bond market and the equity market are distinct market segments that have vastly different characteristics. However, there is one instrument that seamlessly blends the features of these two types of securities — the perpetual bond. Want to find out if this is a suitable investment avenue for your portfolio? To find the answer, you need to understand the meaning of a perpetual bond and how it works.
What are perpetual bonds?
A perpetual bond is a type of debt instrument that has no maturity date. The issuing entity pays out interest on the bond value according to a predetermined rate of interest. Since there is no maturity date, a perpetual bond is not redeemable. So, you continue to receive coupon payments on this security for the foreseeable future.
In this regard, a perpetual bond resembles an equity share because the latter is also not redeemable. The coupon payments from the bond are comparable with the dividend payouts on equity shares, although the former is guaranteed while the latter is not.
Features of perpetual bonds
Perpetual bonds work much like regular bonds, except that they do not have a maturity date. Due to this defining feature, perpetual bonds have certain distinct characteristics, as outlined below.
1. Infinite coupon payments:
Perpetual bonds offer the advantage of infinite coupon payments. As long as you hold the bond, you will continue to receive interest on your investments without any exception.
2. Embedded call option:
Since they do not have any maturity date, most perpetual bonds come with an embedded call option that the issuer can exercise. It promotes liquidity and allows the issuer to redeem the bonds at a predetermined date.
3. No Yield to Maturity (YTM):
This is essentially the yield or return you can expect to earn if you hold the bond till maturity. However, since a perpetual bond does not have a maturity date, it does not have YTM either.
4. No return of the principal:
The lack of a redemption facility means that investors will never receive the principal amount invested. For most investors, this is a huge risk that can only be set off by long-term and consistent coupon payments.
How does a perpetual bond work?
Perpetual bonds are fixed-income securities designed without a maturity date. This means the maturity period of such bonds is not defined at all. The bond issuer keeps paying the interest to the bondholder indefinitely until the organisation or company is solvent. Because these bonds have no maturity date for the principal amount, they do not have a redemption date as well.
Thus, perpetual bonds have a fixed interest rate, and investors issue the loan indefinitely and receive regular interest payments perpetually (in theory). This nature defines perpetual bonds and showcases how they function.
These bonds work by providing the investor with regular interest payments as long as the bond is held. The interest payments, also called ‘coupons’, are usually fixed and paid on an annual or semi-annual basis.
The overall price of these bonds fluctuates based on market conditions, including changes in general interest rates. For example, with an increase in interest rates, the price of perpetual bonds goes down because of the introduction of new bonds in the market. However, you must remember that the bond issuer has the call options with them, and they might choose to redeem the bond with favourable market conditions.
Do coupon payments go on forever?
With a general understanding of perpetual bonds, it is common to question whether coupon payments continue “forever”. The answer, theoretically, is yes. The nature of these bonds suggests that interest payments continue indefinitely. However, that depends on a variety of factors, and the ‘forever’ nature of coupon payments doesn't stand alone. For example, for coupon payments to continue, the issuer must be solvent; that is, they must have the financial capability.
Furthermore, perpetual bonds also have the call option for the issuer. The issuer may use the call option at any time when they see themselves capable of repaying the principal amount. This automatically stops the coupon payments. Now, this anytime call option with the issuer has become a prominent feature of perpetual bonds because of the absence of a fixed redemption date for these bonds.
However, the issuer isn't obligated to pay the principal amount. Thus, generally, the interest payments continue forever. However, investors must be aware of the call options and other factors that can stop this continuation of interest payments.
How to calculate the price of a perpetual bond
The price of a perpetual bond must reflect its strengths and limitations. On the upside, the interest payments are practically infinite. However, on the flip side, there is no return of the principal amount. So, the formula for calculating the price of a perpetual bond only takes into account the coupon payments.
Despite the absence of a maturity date, it is possible to determine the price of a perpetual bond. To do this, you essentially apply a discount rate to all future coupon payments to arrive at the present value of the bond. The formula for this is as follows:
Present value of a perpetual bond = Periodic annual coupon payment ÷ Discount rate |
Let us look at an example of perpetual bond value calculation for more clarity. Say you receive Rs. 20,000 as interest from the bond each year. Using an appropriate discount rate of, say 4%, you can calculate the price of the perpetual bond as shown below:
Present value of the bond (aka its price):
= Periodic annual coupon payment ÷ Discount rate
= Rs. 20,000 ÷ 4%
= Rs. 5,00,000
How to calculate the yield of a perpetual bond
While there is no YTM for perpetual bonds, these instruments do have a current yield value. This yield from a perpetual bond can be calculated using the following formula:
Current yield from a perpetual bond = (Annual coupon payment ÷ Price of the bond) x 100 |
Who issues perpetual bonds?
Perpetual bonds make up a very small portion of the bond market. Generally, they are issued by large financial institutions, including banks, big corporations, and government entities. Now, each of these institutions issue perpetual bonds for different reasons.
Banks use these bonds to enhance their capital base, i.e., to fulfil their requirements for long-term capital. For banks, these bonds come under Tier 1 capital, helping them with financial stability.
Big corporations use these bonds to finance their big projects or to pay off their existing loans. The government uses perpetual bonds to fund big infrastructure projects or to raise capital. Some people also see perpetual bonds as a great measure for the government to repay public debt. Generally, each institution issuing perpetual bonds uses it to create some sense of financial stability and for long-term capital projects.
The benefits of perpetual bonds for investors
Like every other investment avenue, perpetual bonds have many benefits to offer investors despite their few limitations. The top advantages of investing in a perpetual bond include the following:
1. Reliable income:
One of the most preferred benefits of perpetual bonds is that they offer guaranteed income for as long as you hold the instrument. This is useful if you want a reliable source of alternative or additional income.
2. No market-linked risk:
Since perpetual bonds are essentially debt instruments, they do not carry any market-linked risk. That said, they may carry interest rate risks that you need to factor into your investment decision.
3. Higher yields:
Another benefit of perpetual bonds is that they typically offer higher yields or coupon payments. This helps compensate for the limitation of not being able to redeem the bond at all.
Who should invest in perpetual bonds?
Perpetual bonds have a distinct design, making them suitable for certain types of investors. Here's a list of people who can consider investing in perpetual bonds:
- Investors looking for a fixed revenue stream
Perpetual bonds can be an ideal pick for investors looking for a fixed revenue stream. With perpetual bonds, you get a fixed income source, making them an attractive option for individuals looking to keep a consistent income and expense statement flow or for retired individuals. - Long-term investors
As perpetual bonds come with no redemption date or maturity, this feature makes them a suitable option for long-term investors. Long-term investors can hold these bonds for an indefinite period to earn regular coupon payments unless the issuer uses their call option. - Stability-seeking investors
Perpetual bonds are a good choice for individuals looking for more stable bonds with less risk involved. Though no bond is completely free of market risk, these bonds are comparatively stable and have fixed interest payments. - Big institutions
Big institutions also invest in these bonds to create long-term income via regular coupon payments. For example, insurance companies can use perpetual bonds to generate some steady revenue. - Diversified portfolio seekers
Individuals trying to create diversified portfolios to avoid extreme losses due to fluctuations in individual stocks can consider investing in perpetual bonds. They have a distinct nature, and their risk profile also varies from that of other regular bonds or shares.
Conclusion
This sums up the key aspects of perpetual bonds that you must be aware of before investing in such a security. If you do decide to invest in a perpetual bond, ensure that the issuing entity has a high credit rating. The higher the creditworthiness, the more certain you can be of receiving regular coupon payments. This is particularly important to offset the risk of the bond’s irredeemable nature.
