How perpetual bonds work

Bonds are fixed income securities that pay a fixed amount — also known as coupon — periodically. They also fluctuate in price depending on various factors, foremost among them being the change in interest rates. The bond investor can redeem the bond in the market or wait till maturity and receive the principle.

While there are various types of bonds, we will now discuss about perpetual bonds. Recently, many banks issued perpetual bonds to improve their financial condition worsened by stressed assets and bad debts. In fact, in 2014, the United Kingdom called back its perpetual bonds that were issued at the time of the First World War in 1917. This is equivalent to a bond with maturity of 100 years.

Important aspects of perpetual bonds Perpetual interest payment: Perpetual bonds pay periodic interest forever. As such, these bonds have no maturity date.

Pays higher interest than normal bonds: Since there is no maturity date and investors do not get the principle, perpetual bonds pay higher returns than normal bonds. Hence, for the same rating of bonds, you can expect perpetual bonds’ interest to be higher by few percentage points.

High risk: Since the bonds do not have maturity period, they are riskier than normal bonds. For example, if your bond is paying a certain coupon rate and the interest rate goes up, you are stuck with the lower rate and you can’t even redeem it, unless it has the callable feature (as mentioned below).

Low liquidity: Liquidity of perpetual bonds is low because investors who have invested in perpetual bonds expect to receive a certain coupon rate forever. This makes it difficult to redeem it.

Why Companies, Governments and Institutions issue perpetual bonds Perpetual bonds are usually issued by governments or government-owned institutions. There are times when financially strong companies with an excellent corporate history have been able to issue the perpetual bonds. The biggest advantage from the issuer’s perspective is that the issuer doesn’t have to pay the principle. They just have to pay the interest and interest payout saves taxes for the issuer. Moreover, since the principle is never paid, it is not treated as debt in their balance sheet. Thus, it is a two-fold advantage to institutions issuing perpetual bonds.

There is another variant of perpetual bonds, with a feature called callable bond. These bonds promise to pay the coupon forever but can be called back by the company, whenever it wishes to pay the principle and close the bond. This provides immense flexibility to institutions especially when interest rates fall. Usually, the set time for call can be anywhere between five and 10 years.

Important points for investors Investors should invest in perpetual bonds if they have no source of income and need continuous cash flows but do not expect any maturity value. For example, retired people can invest in perpetual bonds. Additionally, they can also be used to augment your current cash flows.

Since perpetual bonds are offered by governments and financially-strong institutions, they are low risk investments. The only risk is interest rate fluctuation. For example, if the coupon rate is 10 per cent in a perpetual bond currently, and if, in future, bank interest rates touch 10 per cent, it would be better to invest in bank deposits that also provide the flexibility to redeem when one wishes.

The pricing of perpetual bond is based on the coupon rate divided by an appropriate discount rate. The discount rate can be rate of inflation or risk free rate such as fixed deposit or interest paid by government securities. Investors can have an idea about the price and can compare the actual price before they buy the perpetual bond. For example, suppose a unit of perpetual bond issued by the Government of India offers to pay a coupon of '1,000 every year forever. The rate on government securities now is eight per cent. Assuming the same risk level, the price of the bond can be calculated as '1,000/8% = '12,500. Finally, perpetual bonds are stable investments and provide a regular cash flow. The returns are quite average, hence investors who want higher returns can look at equities or equity mutual funds. These bonds come with a higher risk though.

The writer is the CEO of BankBazaar.com