Perpetual bonds

Table of Contents

Perpetual bonds
What is a perpetual bond?
Understanding perpetual bonds
Formula for the present value of a perpetual bond
Perpetual bond working
Example of a perpetual bond
Frequently Asked Questions

Perpetual bonds

Various investment opportunities are available depending on your investment horizon, level of risk tolerance, and expected return. Due to the steady returns they provide over time, bonds are one of the most popular investment options. A sort of bond with no set maturity date is called a perpetual bond. Until they call the bonds back, the issuers must pay consistent interest. The bondholders are not given a chance to redeem their bonds.

What is a perpetual bond?

Perpetual bonds, commonly called “consol bonds” or “perp”, are debt instruments without a set maturity date. Investors often view perpetual bonds as stock rather than debt. The inability to redeem perpetual bonds is one of their main disadvantages. They do, however, also have significant benefits. One of the biggest advantages is that investors can count on regular interest payments throughout the loan. Due to the lack of a defined maturity date, the loan lasts most of the borrower’s lifespan.

Banks and other financial institutions frequently use perpetual bonds to generate additional tier 1 (AT1) capital, a lender’s second defence against economic shocks after equity. When the firm experiences financial hardship and its capital ratio drops below a certain threshold, it may either convert to equity or be written down to boost a lender’s equity basis, minimising systemic impact.

Understanding perpetual bonds

Fundamentally, perpetual bonds give fiscally troubled countries a chance to borrow money without repaying it. Several causes support this phenomenon. First and foremost, long-term debt has incredibly cheap interest rates. Second, investors lose money on loans they make to governments at times of high inflation.

By purchasing perpetual bonds, you can avoid searching for a replacement bond investment when your existing one matures. Investors are nevertheless subject to credit risk and interest rate risk. The acquisition will lose value if the interest rate increases over the perpetual coupon rate. To reduce the risk, the issuer occasionally provides a step-up function to raise the coupon rate following the predetermined timetable.

Formula for the present value of a perpetual bond

Investors can use the following formula to determine the yield return they can anticipate receiving from purchasing a perpetual bond:

A perpetual bond’s current yield is calculated by multiplying the cumulative annual coupon payments by the bond’s market price by 100 (to get the interest rate/yield percentage).

So let’s say you invested in a perpetual bond with a US$1,000 par value by purchasing it for US$900 instead of the full US$1,000. Each year, you get paid a total of US$90 in coupon payments. Current Yield = [90 / 900] x 100 = 0.1 x 100 = 10%

The bond currently has a 10% yield.

Perpetual bond working

A perpetual bond can perpetually pay returns like a bond with a maturity date in operation. The issuer may redeem it at some point even though it doesn’t have a specific redemption date because most perpetual bonds have a call feature.

An investor first purchases a bond issued by a government, business, or other entity. The issuer then makes periodic payments to investors to repay their initial investment plus interest. The conditions of the bonds, including the precise interest rate, are decided upon in advance and can differ from bond to bond.

Perpetual bond interest payments are comparable to stock dividends because they offer consistent prices, boosting earnings. The fact that interest payments are frequently fixed, but stock dividends might fluctuate is a significant distinction. Perpetual bondholders have a more extraordinary priority claim than stockholders in the event of bankruptcy of the issuer, just like with any other type of bond.

Example of a perpetual bond

Perpetual bonds have historically been crucial in helping organizations or countries recover from fiscal disasters like debt accumulation. Some examples of perpetual bonds that are well-known worldwide date back to 1752, when a consol bond was issued in Britain. Later, perpetual bonds were sold to pay for the Irish Distress Loan, the Crimean War, the Napoleonic and Crimean Wars, the Slavery Abolition Act, and World War I.

Winston Churchill issued 4% consolation notes in 1927 to refinance obligations from the First World War. In 2020, financial problems returned, and perpetual bonds became significant. They were applied as a fix for the pandemic’s issues.

Frequently Asked Questions

Who issues perpetual bonds?

Governmental organisations and banks are the main perpetual bond issuers.

Who should invest in perpetual bonds?

Retirement investors who desire to secure a predictable income stream that they can count on indefinitely may find perpetual bonds acceptable.

What are the pros and cons of perpetual bonds?

The pros of perpetual bonds are:

Perpetual bonds appeal to investors like other bond types because they offer a steady fixed income stream. The parameters of a bond, including the interest rate, are already decided when it is issued.

Perpetual coupon payments are
Unlike traditional bonds, perpetual bonds have no expiration date and, in theory, may always pay investors interest.
The risk of investing in perpetual bonds is less than investing in equities, even if there is always a chance of default and variable interest rates. The claims of the owners of perpetual bonds will be paid before those of the shareholders if a corporation files for bankruptcy.

The cons of perpetual bonds are:

The cost of missing out on alternative investment opportunities, sometimes known as the “opportunity cost,” is a penalty associated with buying perpetual bonds.

Many perpetual bonds are callable, meaning the issuer may ask for the bond’s redemption after a predetermined amount of time.
If you invest in perpetual bonds, you run the danger of inflation, but your principal and interest payments might rise gradually enough to keep up with inflation. Your ability to buy things may be limited.

Are perpetual bonds a good investment?

Although perpetual bonds are typically considered relatively safe investments, they expose the bond buyer to the issuer’s credit risk for an endless amount of time.

Can perpetual bonds be redeemed?

In most cases, the issuer of a perpetual bond has the right to call or redeem the bond at any point after an established time frame, like five years after the bond’s issuance date. Some perpetual bond issuers finally redeem their obligations as a result.