Table of Contents
- 1 What are Perpetual Bonds – the Definition?
- 2 History of Perpetual Bonds
- 3 Advantages and Disadvantages of Perpetual Bonds for Issuer
- 4 Advantages and Disadvantages of Perpetual Bonds for Investor
- 5 How to Calculate Perpetual Bond Value?
- 6 Perpetual Bond Duration
- 7 Risks to Issuing Banks in India
- 8 Conclusion
What are Perpetual Bonds – the Definition?
Perpetual bonds, as the name suggests, are perpetual in nature. The literal meaning of perpetual is never-ending or recurring. These are types of bonds whose life never ends i.e. the money invested through this stays with the issuer forever. Also, interest income from the bond is recurring throughout life subject to the issuer’s financial strength. There is no need to confuse with the names like ‘Consol bond’, ‘Prep’. They are all the different names of perpetual bonds only.
Financial terminology defines perpetual bonds as irredeemable fixed-income bonds having no maturity. In other words, they are hybrid coupon paying instruments, which by structure, are designed to pay coupons forever clubbed with no maturity. Therefore, financial experts also call them quasi-equity instruments as they resemble more with Equity than a Debt.
History of Perpetual Bonds
In the 18th century, around the year 1720, the name of the British Government is traced for issuing perpetual bonds for raising money at the time of World War I. For governments, some experts recognize such bonds as a savior in turbulent economic times.
Advantages and Disadvantages of Perpetual Bonds for Issuer
The prime advantages to the issuer by issuing such a bond are as follows:
- For issuers, such bond issues save refinancing or issuing costs in the long run.
- It avoids risks associated with the capital markets. All the times are not the same. It is possible that in the future when the need arises, the market scenario may not allow acquiring finances. Or the cost of fund acquisition could be higher i.e. both interest rates as well as issuing costs.
- Bigger and time-bound project opportunities can be grabbed when funds are on hands.
- Bonds with Callable features have an additional advantage of redeeming the bonds in favorable economic and interest rate scenarios.
Some of the main disadvantages of issuing such bonds are as follows:
- The biggest disadvantage of these bonds is that the issuer has no choice but to keep the money with it and pay interest forever whether it needs it or not.
- The interest rate scenario changes with time. For all other sorts of funds, an issuer would prefer to repay in declining interest rate scenario and acquire fresh funds at lower rates and vice versa. But, in the case of these bonds, the issuer has to bear with a less optimized capital structure.
Such a bond can be issued with ‘Call Feature’ embedded in it. It enables the issuer to use it to their advantage in accordance with the interest rate scenario prevailing at that point in time.
Advantages and Disadvantages of Perpetual Bonds for Investor
The prime advantages to the investor by subscribing to such a bond are as follows:
- For investors, such bond issues save time and energy wasted in reinvesting their matured funds.
- When the rates are falling and there are few avenues to profitably deploy the surplus, large investors go hunting for instruments offering a higher yield. Since perpetual bonds are a subordinate debt of larger corporations or banks, they provide a notional sense of safety and a higher yield at the same time.
- This is a regular source of income that is received on an annual basis and investors can expect to continue for a long time if the issuer is financially sound.
Disadvantages of investing in such bonds are as follows:
- The first visible disadvantage is that the fund is blocked forever. The exit from such bonds is dependent on the liquidity in the bond trading market.
- Since there is no option to withdraw the sum, consequently, the investor cannot invest in other lucrative opportunities in rising interest rate scenarios.
- In favorable interest rate scenarios, the issuer can call back perpetual bonds with the callable feature.
- The risk associated with such an investment is as good as equity holders.
- Exposure to higher insolvency risk due to an infinite period.
How to Calculate Perpetual Bond Value?
The accounting principle “Going Concern” is applicable here and that sets the basis for the company to pay dividends indefinitely. This concept forms the basis of “Dividend Discount Model”. If we look at the construct of the formula in perpetuity and its derivation, it closely resembles the Dividend Discount Model.
Formula & Derivation
Perpetual Bond is an infinite series coupon paying bond, hence mathematically its Present Value can be written as follows:
PVA∞ =A (1+K)-1+ A (1+K)-2+……….A(1+K)-∞+1 +A(1+K)-∞
Multiplying both the sides of the above equation by (1+K) we get
PVA∞ (1+K) = A+ A (1+K)-1+………..A (1+k)∞+1
Subtracting the previous equation from the latter one we get
Mathematically 1/ (1+K) ∞ tends to 0, hence the equation above can be rewritten as
Where A= Coupon Payment (Annual Payment)
K= Discount Rate applicable for the bond
Perpetual Bond Duration
The duration of a bond measures the sensitivity of the value/price of a bond with respect to changes in prevailing interest rates. The formula used to calculate the duration of a perpetual bond is (1+Yield) / Yield. It is expressed in Years.
Risks to Issuing Banks in India
As the name suggests, these are the bonds that come into the picture to raise long-term finance. Firstly, the investor’s primary expectation is to receive timely coupon payments every year. Hence, on close observation, it may look like a preferred dividend payment to a preferred stockholder. Mainly, large entities like Banks issue such bonds since they are an attractive source of Tier 1 capital. That is also the cornerstone of establishing the capital adequacy of a Bank or a Financial Institution.
These bonds form part of the AT1 (Additional Tier 1 Capital) of the bank. Bank and other entities are liberally using this route for raising money nowadays. As we have discussed in the above segments that Perpetual Bonds have quasi-equity characteristics, hence it is important to fully understand its implications. Perpetual bonds are classified as Additional Tier 1 capital as per the norms and are thus open and supposed to absorb the risk which banks might have to face.
If a bank is in trouble on the revenue front or on account of bad loans, it is bound to have serious repercussions not only on the profitability but also on the capital of the bank. These bonds can be written down or can be converted into core equity if there are losses on account of the reasons stated above or otherwise. The coupon payment can also be abated if the capital ratio plunges below the acceptable point.
According to BASEL III standards, the coupon can only be paid out of the profits earned in that particular financial year. Hence this implies if a bank incurs a loss in a financial year, it is not supposed to pay a coupon on a perpetual bond even if it can pay.
To conclude, it is critical for investors to seek a favorable trade-off between the yield (they wish to earn) and the risk (which is primarily the credit risk). So, it is advisable to undertake this investment after proper due diligence on the long term prospects of the institution.1,2