When companies and governments need to raise money, they issue bonds. Investors purchase the bonds, essentially making loans to the issuer. In exchange for the loans, the issuer agrees to make interest payments to the bond buyer for a specific time period.
With perpetual bonds, the agreed-upon period over which interest will be paid is “forever", as perpetual bonds live up to their name and pay interest in perpetuity. In this respect, perpetual bonds function much like dividend-paying stocks or certain preferred securities. Just as the owner of the stock receives a dividend payment as long as the stock is held, the perpetual bond owner receives an interest payment as long as the bond is held.
History and Future of Perpetual Bonds
Perpetual bonds have a long history. The British government is often credited with creating the first one way back in the 18th century. While they are not anywhere near as popular as the more familiar Treasury bonds and municipal bonds, perpetual bonds continue to be issued today.
An argument can be made that issuing perpetual bonds would be an attractive proposition for indebted global governments. To fiscal conservatives, the idea of issuing any debt doesn't sound good, and debt that never ends would be positively unfathomable, but perpetual bonds have a certain appeal during troubled times.
At its most basic, issuing perpetual bonds would permit a fiscally challenged government to raise money without ever needing to pay it back. Several factors support this approach. The first is that interest rates are extraordinarily low for longer-term debt. The second is that once inflation is factored into the equation, investors are actually losing money on the loans they make to the government.
For example, when the interest rate the investors receive is 0.5% and inflation is at 1%, the result is an inflation adjusted interest rate of return for the investors of -0.5%. In dollars and cents, this means that when investors get their money back from the government, its buying power will be diminished.
Think of it like this: the investor loaned the government $100, and one year later, the investment's value is $100.50 courtesy of the 0.5% interest rate. But because inflation is running at 1%, it now takes $101 to purchase the same basket of goods that cost just $100 one year ago. Unfortunately, the investors have only $100.50. The rate of return on their investment failed to keep pace with rising inflation.
Since over time inflation is expected to increase, lending out money today at a hypothetical 4% interest rate will seem like a bargain to government bean counters in the future when inflation hits 5%. Of course, most perpetual bonds are issued with call provisions that permit the issuer to make repayment after a designated period has passed. So the “perpetual” part of the package is often by choice, rather than by mandate, and can be eliminated should the issuer have the cash on hand to repay the loan.
Benefits for Perpetual Bond Investors
Perpetual bonds are of interest to investors because they offer steady, predictable sources of income. The payments take place on a set schedule, and some even come with a “step up” feature that increases the interest payment at a predetermined point in the future. In technical terms, this is referred to as a “growing perpetuity.”
For example, a perpetual bond may increase its yield by 1% at the end of 10 years. Similarly, it may offer periodic interest rate increases. Paying close attention to any step-up provisions is an important part of comparison shopping for investors looking for perpetual bonds. A growing perpetuity can be good for your pocketbook.
Risks for Perpetual Bond Investors
A variety of risks are associated with perpetual bonds. Perhaps the most notable is that a perpetual period is a long time to carry on credit risk. As time passes, bond issuers, including both governments and corporations, can get into financial trouble and even fail.
Perpetual bonds may also be subject to call risk, which means that the issuer can recall them.
Another significant risk associated with time is that general interest rates may rise as the years pass. If rates rise significantly, the interest rate paid by a perpetual bond may be much lower than the prevailing interest rate, meaning investors could earn more money by holding a different bond. In such a scenario, the perpetual bond would need to be sold on the open market, at which time it may be worth less than the purchase price as investors discount their offers based on the interest rate differential.
Determining the Value
Investors can figure out how much they will earn (the bond’s yield if held until maturity) by performing a relatively simple calculation. The formula and an example are provided below:
Current Yield = Annual Dollar Interest Paid / Market Price x 100%
(0.05 x $100) / $99.52 x 100% = 5.21%
Since perpetual bonds have no maturity date, the payments (in theory) will continue forever.
Since money loses value over time (inflation plays a role here), the interest rate payments made by a perpetual bond have less value to investors as time passes. The price of a perpetual bond is therefore the fixed interest payment, or coupon amount, divided by the discount rate, with the discount rate representing the speed at which money loses value over time. For perpetual bonds that offer a growing perpetuity, yet another mathematical formula can be employed to determine its value.
If all of this math is making your head spin, don’t fret. In the age of modern technology, there is a much faster way to get this information. Rather than making manual calculations with pen and paper, you can just log on to the internet and search for “yield on a perpetual bond calculator." Type in some information, including the bond’s price and the number of annual interest payments it will make, and the calculator will automatically determine that bond’s interest rate. It’s the fast and easy way to do the math.
The Bottom Line
If perpetual bonds have caught your interest, several are available in the financial marketplace. Many of them are overseas in markets such as India, China and the Philippines. A quick online search will help give you a place to start, as you will easily find references to securities such as those issued by Cheung Kong (Holdings), Agile Property Holdings and Reliance Industries.
If you get a little more serious, you can always place a call to your local broker, who should not only be able to provide a list of offerings but also discuss the pros and cons of specific securities.