An understanding of perpetual bonds, their definition, formulating them at their present value, and learning about their issuers are established in this article.
What is a Perpetual Bond?
Also known as a consol bond or prep, perpetual bonds can be understood to be fixed income securities that do not have a maturity date in place. This form of a bond is ordinarily understood to be an equity instrument as opposed to a debt instrument.
While perpetual bonds can be understood to be debt obligations, the obligation here isn’t compulsory. This is owed to the fact that the debt isn’t required to be repaid by the issuer so long as they continue to make interest or coupon payments that are owed to those that hold perpetual bonds.
One of the primary drawbacks that persists with perpetual bonds is one of its characteristic traits which happens to be its lack of redeemability. That being said, perpetual bonds still draw in investors owing to the fact that they provide them with a steady source of interest payments in continuity forever.
Understanding the Scope of Perpetual Bonds
Perpetual bonds occupy a small niche within the realm of bonds. This is owed to the fact there exists a minuscule number of entities that are safe enough for investors to invest in a bond where they will never be repaid for the principal they invest.
From a historical point of view, some of the perpetual bonds of note are those that were issued by the British Treasury during World War I as well as those that were issued for the South Sea Bubble in 1720.
Looking at Perpetual Bonds with the aid of an Example
Owing to the fact that perpetual bonds exist in a manner similar to stock dividend payments, it is no surprise that they are priced in a similar fashion. The price of a perpetual bond is a fixed interest payment or coupon amount that is divided by a given constant discount rate that is representative of the speed by which money diminishes in value over time of which some may be owed to inflation. This denominator which serves as a discount rate is responsible for the real value of the minimally fixed coupon amounts to fall over time ultimately resulting in the value amounting to zero. Although perpetual bonds provide investors with interest forever, they can be given a finite value that is consequently representative of their price.
When applied to a formula, the present value of a perpetual bond can be understood to be
Present value = D / r
Here, D = the periodic coupon payment applicable and r = the discount rate made use of on the bond.
For example, should a perpetual bond pay USD15,000 each year in the form of perpetuity and the discount rate applicable is taken to be 3%, the present value would amount to –
Present value = USD 15,000 / 0.03 = USD 500, 000.
It is important to understand that the present value of a perpetual bond is incredibly attuned to the discount rate assumed owing to the fact that the payment is understood to be a fact.
Perpetual bonds v/s Dividend Payments v/s Annuities
While perpetual bonds are considered similar to equity investments that provide their investors with dividend payments (and as was mentioned in the previous section), the similarity between the two is limited and superficial.
Divided payments that are made to a given stock’s shareholders are ordinarily not fixed in the amount owed but vary with time and in accordance with how a company performs. In contrast, coupon payments made on perpetual bonds are of a fixed value that doesn’t change over time. Moreover, those who hold perpetual bonds don’t hold anything that may be of equal value as the voting rights held by those who own a stock’s shares.
Instead, perpetual bonds can be more closely linked with annuities. An annuity can be understood to be an investment that is theoretically capable of providing investors with a continuous source of income payments. Similarly, coupon payments applicable under perpetual bonds provide bondholders with continuous income payments that last for indefinite periods of time.
Are Coupon Payments Truly Unending?
It isn’t out of the ordinary for people to be skeptical of the unending issuance of coupon payments to those who avail of perpetual bonds. That being said, they most definitely do provide unending payments to their bondholders.
From a practical aspect, issuers of perpetual bonds are ordinarily entitled to call or redeem their bonds at any point in time following a certain specified time frame which could be 10 years following the issuance of the bond. Issuers benefit from the fact that these bonds do not have fixed redemption rates. Owing to this fact, the issuer is responsible for selecting the time of redemption. Bondholders can choose to wait to redeem their bonds when they can afford to do the same with ease. Keeping in mind the flexibility on offer with regards to the repayment of the bond holder’s principal amount could very well be the primary reason as to why an issuer chooses to select and issue perpetual bonds.
One of the more pressing characteristic features of perpetual bonds is that those that issue the same aren’t legally required to return the principal amount invested by investors.
Issuers of Perpetual Bonds
Perpetual bonds are primarily issued by government entities in addition to banks. Banks issue these bonds in order to generate the funds needed to meet their requirements for capital. The money brought in via investors in order to obtain these bonds falls under Tier 1 capital.
While some economists are firm believers in the virtues of perpetual bonds owing to the fact that they can help financially strained governments generate money, other economists don’t believe in the idea of debt generation that isn’t intended to be repaid. Furthermore, they don’t view it as a sound fiscal policy for a government to be contractually obligated to make payments to anyone in perpetuity.