Perpetual Subordinated Loan

What Is a Perpetual Subordinated Loan?

A perpetual subordinated loan is a type of junior debt that continues indefinitely and has no maturity date. Perpetual subordinated loans pay creditors a steady stream of interest forever. As the loan is perpetual, the principal is never repaid so the interest steam never ends. Essentially, the borrower pays interest as a fee for access to the money but never fully repays the principal. The interest rate is based on the borrower’s creditworthiness, as well as prevailing market interest rates.

How a Perpetual Subordinated Loan Works

As the name suggests, with perpetual bonds, the agreed-upon period over which interest will be paid, is forever—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 perpetual subordinated loans are a type of junior debt, they are relatively riskier for the creditor. They are secondary to unsubordinated loans (senior loans), so if the borrower of a perpetual subordinated loan defaults, the creditor won’t get repaid until the borrower’s unsubordinated loans are repaid. Because of the increased risk associated with subordinated loans, they will have higher interest rates than unsubordinated loans. Creditors can use a present-value calculation to determine the present value of a future series of perpetual subordinated loan payments.

Benefits of Perpetual Bonds

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, their 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.

Risks of Subordinated Perpetual Bonds

There are risks associated with all 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, the 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.

For subordinated perpetual bonds, the added risk of being less senior for creditors makes it additionally risky. As a result, these carry higher interest rates than senior perpetual bonds.