When companies and governments aspire to raise money, they may issue bonds. Investors who purchase those bonds are essentially extending loans to the issuing entities, where in exchange for these loans, the issuer agrees to make interest payments to the bond buyer, for a specific time period.
As the name suggests, with perpetual bonds, the agreed-upon period of time over which interest will be paid, is forever (aka: in perpetuity). In this respect, perpetual bonds function similarly to dividend-paying stocks or certain preferred securities. Just as owners of such stock receive dividend payments for the entire time the stock is held, perpetual bond owners receive interest payments, for as long as they hold onto the bond.
- As the name suggests, with perpetual bonds, the agreed-upon period of time over which interest will be paid, is forever (aka: in perpetuity).
- Perpetual bonds are recognized as a viable money raising solution, during
troubled economic times.
- Perpetual bonds have carry on credit risk, where bond issuers can experience financial trouble or shut down.
History and Future of Perpetual Bonds
The British government is widely credited with creating the first perpetual bond, back in the 18th century. Although they’re currently not nearly as popular as Treasury bonds and municipal bonds, many economists believe perpetual bonds are attractive capital raising solutions for indebted global governments. On the other hand, fiscal conservatives generally oppose the prospect of issuing any debt – let alone bonds that perpetually pay interest to holders. Nevertheless, perpetual bonds are recognized as a viable money raising solution, during troubled economic times.
Perpetual bonds fundamentally afford fiscally-challenged governments an opportunity to raise money without the obligation of paying it back. Several factors support this phenomenon. Primarily, interest rates are extraordinarily low for longer-term debt. Secondly, in periods of rising inflation, investors actually lose money on loans they make to governments.
For example, when investors receive a 0.5% interest rate, where inflation is 1%, the resulting inflation adjusted interest rate of return is -0.5%. Consequently, when investors receive money back from the government, its buying power is drastically diminished.
Consider a scenario where an investor loans the government $100, and one year later, the investment's value climbs to $100.50, courtesy of the 0.5% interest rate. However, due to a 1% inflation rate, it now requires $101 to purchase the same basket of goods that cost just $100 one year ago, therefore the investor’s rate of return fails to keep pace with rising inflation.
Most economists expect inflation to increase over time. As such, lending out money at a hypothetical 4% interest rate seems like a bargain to government bean counters, who believe the future inflation rate could spike to 5% in the near future. Of course, most perpetual bonds are issued with call provisions that let issuers make repayments after a designated time period. In this regard, the “perpetual” part of the package is often a choice, rather than a mandate, because issuers can effectively squash the perpetual obligation, if they have enough cash on hand to repay the loan in full.
Benefits for Perpetual Bond Investors
Perpetual bonds are of interest to investors because they offer steady, predictable sources of income, with payments made on a set schedule. Furthermore, some perpetual bonds boast “step up” features that increase the interest payment at predetermined points in the future. Technically referred to as a “growing perpetuity,” this function can be quite lucrative for investors. For example, perpetual bonds may increase their yield by 1% after 10 years. They may similarly offer periodic interest rate increases. Therefore, investors should play close attention to any step-up provisions, when comparison-shopping for different perpetual bond offerings.
Risks for Perpetual Bond Investors
There are risks associated with perpetual bonds. Notably, they subject investors to perpetual credit risk exposure, because as time progresses, both governmental and corporate bond issuers can encounter financial troubles, and theoretically even shut down. Perpetual bonds may also be subject to call risk, which means that issuers can recall them. Finally, there is the ever-present risk of the general interest rates rising over time. In such cases where the perpetual bond’s locked in interest is significantly lower than the current interest rate, investors could earn more money by holding a different bond. However, to swap out an old perpetual bond for a newer, higher interest bond, investor must sell their existing bond on the open market, at which time it may be worth less than the purchase price, because investors discount their offers based on the interest rate differential.
Determining the Value
Investors can determine what they will earn (the bond’s yield if held until maturity) by performing a relatively simple calculation, using the following formula:
Current Yield = Annual Dollar Interest Paid / Market Price x 100%
(0.05 x $100) / $99.52 x 100% = 5.21%
Keep in mind that perpetual bonds have no maturity date, therefore payments theoretically continue forever.
Since money loses value over time, due to inflation and other causes, over time, the interest rate payments made by a perpetual bond have less value to investors. 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.
Investors who find these calculations daunting can simply search online for a “yield on a perpetual bond calculator." By entering the bond’s price and the number of annual interest payments it will make, the calculator will automatically determine that bond’s interest rate.
The Bottom Line
If perpetual bonds have sparked your interest, there are copious opportunities to fold them into your investment portfolio, including overseas offerings in markets such as India, China and the Philippines. A quick online search can easily refer you to such investments, like those issued by Cheung Kong (Holdings), Agile Property Holdings and Reliance Industries. Investors may also consult with brokers, who can furnish lists of offerings, and highlight the pros and cons of specific securities.