Perpetual bonds do not have a maturity date but the investors will get a steady stream of interest. However, the investors may never get their initial investment back. So, is investing in perpetual bonds a smart call?
This article explores how perpetual bonds work, their formula and calculating the value, its impact on debt funds, who should invest in perpetual bonds and their advantages and limitations. Read on!
Perpetual bonds, also known as “consol bonds” or “perp”, are debt instruments that do not have a specific maturity date. Many investors perceive perpetual bonds as equity instead of debt. The major drawback associated with perpetual bonds is the inability to redeem them. However, they also have significant advantages. One of the most notable advantages is that investors can expect a consistent stream of interest payments throughout the loan duration. Since there is no maturity date, the loan duration is practically the entire life of the borrower.
Financial institutions and governments issue perpetual bonds to raise funds using fixed coupons or interest rates. If the bond maker wishes to redeem the bonds, the bond buyers will get a steady stream of income for the rest of their lives. These bonds are not regulated by any law that mandates the issuer to repay the principal.
There may not be a redemption date on them, but issuers redeem them at some point using the call feature. The purchase procedure involved the investor buying a bond issued by the government, a corporation, or any other organization. The issuer promises to repay the loan to the investors with the interest. The repayment is done through fixed regular payments. Bonds differ based on terms, interest rates, etc.
Perpetual bonds are generally regarded as a safe investment option. However, bond buyers face a credit risk. Investors may also incur losses in case the interest rates in the market exceed the investor bond coupon rates. Higher coupon rates can be offered for a fixed time to mitigate the risk. The time will depend on the bond’s current market rate.
While perpetual bonds are starkly different from equity investments, they still resemble equity more than debt. Thus, they are considered fair.
The “Going Concern” accounting principle applies to perpetual bonds. This means that the company may pay indefinite dividends. This is the underlying principle behind the “Dividend Discount Model”. A formula and derivation of perpetual bond value are also similar to the dividend discount model.
1. Perpetual Bond Formula:
A perpetual bond is a type of bond that pays infinitely. The present value of the perpetual bond can be mathematically presented below:
PVA∞ =A (1+K)-1+ A (1+K)-2+……….A(1+K)-∞+1 +A(1+K)-∞
The next step is to multiply both sides of this equation by (1+k)
PVA∞ (1+K) = A+ A (1+K)-1+………..A (1+k)∞+1
Now, subtract the first equation from the second to get the below:
Below is how the above equation can be rewritten since 1/ (1+K) ∞ tends to 0
A= Annual Coupon Payment
K= bond discount rate
In history, perpetual bonds have significantly helped entities or nations recover from financial crises such as debt accumulation. Some globally known perpetual bond examples date back as far as 1752, when a consol bond was issued in Britain. Later, perpetual bonds were issued to finance the Slavery Abolition Act, the Napoleonic and Crimean Wars, the Irish Distress Loan, and World War I. As a chancellor, Winston Churchill issued 4% consols in 1927 to refinance bonds that dated back to the First World War.
Financial crises resurfaced in 2020 and perpetual bonds started gaining importance again. They were used as a remedy to issues caused by the pandemic.
Bond investment is a beneficial decision. However, one must know perpetual bond meaning to know their features and terms and make an informed decision. Banks issue perpetual bonds to make up for their lack of capital. Post the recession in 2008, as banks and financial institutions declared bankruptcy, higher capital adequacy norms were introduced. This allows banks to skip paying the principal or interest if their capital adequacy ratio goes below a certain threshold.
To safeguard themselves from any systemic risks, banks must maintain a capital adequacy ratio of 10.875%. They must also maintain a Capital Conservation Buffer of 1.875%. Banks thus try to maintain the capital adequacy ratio above the threshold defined by regulations.
Since perpetual bonds do not have a predefined maturity, issuers can usually redeem them after 5-10 years. Issuers can either redeem or call bonds if they wish to refinance the issue at a cheaper rate. This is greatly useful in scenarios where interest rates are going down.
Banks can also choose to pay regular interests to investors or skip and extend bond duration.
Indian investors choosing perpetual bonds can open a source of fixed income. This will be long-term recurring income because there is no maturity date on these bonds. Perpetual bonds in India offer a higher return on investment as compared with other available investment tools. These coupon payments are likely to become forever income for perpetual bond holders. The annual perpetual bond coupon will be added to the total income of the investor and tax will be applied based on the income tax slab they fall in. However, a bond sale in the secondary market that leads to long-term capital gain for investors will attract long-term capital gains tax. The rate of this tax is 10% without indexation.
Banks, corporates, individual investors, and mutual funds can invest in perpetual bonds. These investments can help to earn interest income and fulfill specific financial goals. Investors must be mindful of their risk appetite before choosing the investment amount.
A SEBI circular dated March 15, 2021, caused ripples in the debt mutual fund investment space. The industry has assets worth nearly Rs.35000 crores in perpetual bonds. These have been issued by banks. This means SEBI directs mutual funds to regard perpetual bonds as instruments with a tenure of 100 years. The limit on investments by debt funds in these perpetual bonds is 10%. This includes AT-1 bonds and Tier-2 bonds.
The ministry of finance requested to withdraw the circular directing valuing perpetual bonds in 100 years. This is because the finance ministry has an opinion that this could cause debt fund investors to panic and redeem and thus increase the borrowing costs for banks. Also, the circular came amidst the pandemic and the finance ministry believed that it could significantly increase the borrowing costs.
The yield of perpetual bonds issued by banks increased. The rise in bond yields could lead to a fall in the net asset value of debt mutual fund schemes holding perpetual bonds.
SEBI’s directive wants the mutual fund houses to value perpetual bonds in a way that the principal will be paid back only after 100 years. This could lead to a steep decline in the value of perpetual bonds because of infrequent trades.
Many mutual fund houses currently value perpetual bonds, assuming that issuers would call within 5-10 years. If the SEBI 100-year rule were to go through, it would make the NAV of several debt funds very volatile.
On March 31, 2022, SEBI issued another circular and amended the valuation rule for perpetual bonds. This circular defines the residual maturity of AT-1 bonds as ten years. Over the next 6 months, the maturity increased to 20 and 30 years. However, it is expected that post-April 2023, the maturity of AT-1 bonds will be 100 years from the issuance date of the bond.
Investors seeking both regular income and capital protection can choose any fixed-income investment instruments. It is wise for senior citizens to avoid debt funds or AT-1 bonds. The rule of thumb of being mindful of your risk tolerance before making investment decisions applies here.
Perpetual bonds are beneficial investment options that can help to create a steady flow of income for investors and allow banks or governments to fulfill capital requirements. However, they aren’t free of risk. Investors must keep the potential risks in mind and make an informed decision based on their tolerance.
Ans: There isn’t very high risk associated with perpetual bonds. However, the issuer’s credit risk may impact the investors. There is also an interest rate risk and liquidity risk. This means the issuer can write off interest and principal if they are at risk of bankruptcy. They can also refinance the bonds. It is a good idea to assess risk tolerance before investing in perpetual bonds.
Ans: Perpetual bonds do not have a predetermined maturity date on them. They can possibly go on throughout an investor’s lifetime.
Ans: Companies issue perpetual bonds to fulfill capital requirements. There is no maturity date on these bonds and there is no legal liability to repay the principal and thus they are regarded as equity financing. They help to reduce the debt portion of the capital structure of the organization.
Ans: Yes, perpetual bonds can be liquidated in secondary markets.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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