Understanding Perpetual Bonds: Benefits, Risks, and Valuation

What are Perpetual Bonds?

As the name suggests, perpetual bonds are permanent. "Perpetual" means never-ending or continuous. The money invested in these bonds stays with the issuer forever, while the interest income flows in depending on the issuer’s strength. Perpetual bonds are also known as “Prep” or “Consol Bonds” but essentially mean the same thing.

Perpetual bonds are fixed-income instruments with no maturity date, meaning they can’t be redeemed. They are hybrid coupon-paying instruments structured to pay coupons forever. Financial experts call them quasi-equity instruments because they have more equity-like characteristics than debt.

History of Perpetual Bonds

Perpetual bonds were first issued around 1720 in the 18th century by the British government to raise money during World War I. Some experts think these bonds can be a lifeline for governments during economic crises.

Perpetual Bonds for Issuers

Benefits:

1. Savings on Refinancing and Issuing Costs
   Perpetual bonds can save issuers on refinancing and issuing costs.
2. Avoiding Capital Market Risks
   Issuers can avoid future market risks, including higher interest rates and issuing costs.
3. Long-term Project Funding
   These bonds provide funding for bigger, longer-term projects.
4. Callable Bonds
   Callable bonds allow issuers to redeem them under favourable economic or interest rate conditions.

Drawbacks:

1. Permanent Interest Payments
   Issuers have to pay interest forever, which ties them in for the long term.
2. Interest Rate Fluctuations
   When interest rates go down, issuers may want to repay and refinance at lower rates. However, perpetual bonds won’t allow them to do that, so they end up with a suboptimal capital structure.
3. Call Feature
   Issuers can include a “call feature” to redeem bonds when interest rates are favourable, but they are still exposed to interest rate risks.

Perpetual Bonds for Investors

Benefits:

1. No Reinvestment Required
   Investors don’t have to reinvest maturing funds as perpetual bonds never mature.
2. Higher Returns in Low Rate Environment
   During low interest rate periods, perpetual bonds offer higher returns, making them attractive to big investors. These bonds issued by big corporations or banks provide a sense of security and higher yields.
3. Fixed Income
   Investors can expect a fixed income as long as the issuer is financially stable.

Drawbacks:

1. Funds Locked Indefinitely
   Investors’ funds are locked in indefinitely and can only exit these bonds when the bond market is liquid.
2. Missed Opportunities
   No withdrawal option means investors can’t take advantage of other opportunities.
3. Callable Feature
   Issuers can call back perpetual bonds with a callable feature that affects investors’ income flow.
4. Equity-like Risks
   Investors are exposed to equity risks if the issuer is financially distressed.
5. Increased Insolvency Risk
   The perpetual nature of these bonds increases the risk of insolvency.

How to Calculate Perpetual Bond Value

The going concern principle of accounting allows a company to pay dividends forever. Perpetual bond value is calculated using a formula similar to the Dividend Discount Model.

Risks for Indian Issuing Banks

Big institutions like banks issue perpetual bonds to raise long-term funding. These bonds are part of Additional Tier 1 (AT1) capital, which is key to determining a bank’s capital adequacy.

When a bank is financially stressed, say due to poor revenues or bad loans, its capital and profitability can be severely impacted. If the capital ratio goes below the required level, AT1 bonds can be reduced or converted into core equity. Coupon payments can be stopped if the bank makes losses. As per Basel III, coupons are only paid if the bank makes profits in a particular year.

Conclusion

Investors should weigh the returns they expect against the risks, especially credit risk. Do thorough due diligence on the institution’s long-term prospects before investing in perpetual bonds. This bond offers a unique investment opportunity with a steady income and potentially higher returns in a low-rate environment. But the perpetual nature of these bonds comes with risks like lack of liquidity, missed reinvestment opportunities and issuer’s financial instability. For issuers, perpetual bonds provide long-term funding and savings on refinancing costs, but they also mean permanent interest payments and interest rate risks. Ultimately, both investors and issuers should assess the benefits and risks to ensure perpetual bonds fit their financial goals and risk appetite.