What are Perpetual Bonds?
A perpetual bond, or a perp bond, is an irredeemable bond with a perpetual fixed income. In other words, it is a bond with no maturity date and cannot be redeemed. The purpose of a perpetual bond is to earn regular interest income perpetually, i.e. Therefore, these bonds do not have a maturity date or a maturity value.
Like dividends from equity shares, perpetual bonds also indefinitely provide regular income. Therefore, perpetual bonds are sometimes considered a part of equity, and their prices are determined akin to equity shares. Moreover, perpetual bonds create a perpetual debt obligation for the issuer, only in name, as the issuer does not have to repay the amount.
Why invest in Perpetual Bonds in India?
An investment in a perpetual bond is a guaranteed way to earn a fixed income. The secured income is usually for a more extended period since such bonds lack maturity feature. Not to mention, the return on investment on such bonds is more than other investment tools available in the market.
Here are the three primary reasons to invest in a perpetual bond:
Fixed Income Opportunity
Such bonds are the primary source of earnings for an investor looking for a source of fixed income. Such investment does not have any maturity. Hence, the interest earned from a perpetual bond is repetitive.
Investing in perpetual bonds in India is acknowledged as an investment that provides higher returns. Such returns are in the form of interest. As a perpetual bondholder, you can receive interest forever as coupon payments.
Perpetual Bonds Taxes
The annual perpetual bonds coupon are added to the total income of an investor and then taxed accordingly, as per the Income Tax slab. However, if the investor earns a long-term capital gain (after a holding period of 1 year) while the bond is sold in the secondary market, then tax is applicable.
The long-term capital gains tax will be levied at 10% minus indexation.
Note: Due to the rise in inflation, investors are stepping back from the equities market to a more secure fixed source of income. Long-dated perpetual bonds with higher yields are the preferred option for such investors.
What You Need To Know Before Investing in Perpetual Bonds
With time, perpetual bonds have gained popularity among individual investors. However, there are certain risks involved that you need to know before investing in such bonds.
A perpetual bond is an exclusive investment that varies from other kinds of fixed-income products and where redemption is an uncertain element.
The redemption usually happens with the consent of the issuer, however, it is influenced by certain market factors like present bond price, interest rate level, bond structure, etc.
Lack of Voting Rights
The majority of perpetual bonds are considered equity, according to accounting standards. It is because coupons are paid out periodically, and redemption is not guaranteed.
The holders of bank equity or company can vote on matters that need shareholder input. However, bondholders do not enjoy such privilege, even with perpetual bonds.
Subordinated Nature of Perpetual Bonds
The superiority of a bond evaluates the priority where investors are repaid if an issuer defaults or moves into liquidation.
Equity products and fixed income can be categorized as per their repayment priority, and the senior secured bonds are entitled to get paid first during liquidation or bankruptcy.
Due to discretionary coupons, bond issuers can pay coupons at their convenience without compulsion. Investors who buy bonds integrated with such a feature are entitled to the risk of not getting a coupon payment during the bond tenure.
Why Do Banks Issue Perpetual Bonds in India?
Banks issue perpetual bonds in India to address long-term capital requirements. As per the features of such bonds, banks pay the perpetual bonds last during liquidation before equity investors. In banks, such bonds fall under the Additional Tier I bonds.
The coupon payment for such bonds is based on the issuing bank’s present-year profitability. The capital adequacy ratio that an issuing bank needs to maintain is 10.875% (minimum) with a Capital Conservation Buffer of 1.87%.
Note: The yield of perpetual bonds is higher than 200 points compared to government bond yields.
Looking at Perpetual Bonds with the aid of an Example
Perpetual bonds are priced similar to stock dividend payments. When transformed into a formula, the current value of a perpetual bond is:
Present Value = D/r
D = the applicable periodic coupon payment
r = the discount rate
For instance, if a perpetual bond pay USD 21000 every year as perpetuity when the discount rate is 3%, the current value will amount to:
Present Value = USD 21000 / 0.03 = USD 700,000.
Who Issues Perpetual Bonds?
Perpetual bonds capture only a small part of the bond market. The main issuers of perpetual bonds are banks and government entities.
Banks issue a perpetual bond to meet the growing capital requirements. The funds acquired from investors for such a bond are certified as Tier 1 capital.
Are Coupon Payments Truly Unending?
The unending issuance of coupon payments for those who avail of perpetual bonds is a reality.
In the practical sense, issuers of perpetual bonds are usually subjected to redeem or call their bonds at any time during a certain period. It could be 10 years after the issuance of the bond.
Perpetual bond investors can wait to redeem their particular bonds when they can do it without any inconvenience. The issuer’s advantage is that such bonds lack fixed redemption rates. Because of this, the issuer is accountable for choosing the time of redemption.
Benefits of Perpetual Bonds
Perpetual bonds have various benefits for both investors and the issuer. Let us discuss its advantages for each of the mentioned parties in detail.
Benefits for Issuer
✓ Results in Cost Savings – Issuing perpetual bonds saves the issuer from the costs that he might have had to incur on reissuing bonds. It saves the costs of reissuing hybrid perpetual securities such as the prospectus, underwriting, brokerage, allotment, etc.
✓ Avoids Capital Market Risk – It is well known that capital markets are highly volatile in nature and any bond or stock within the capital markets is subject to an increase or decrease in market rates. Since perpetual bonds are not listed on the capital markets, they help avoid the risk associated with capital markets.
✓ Better Growth Opportunities – The issuers can invest in long-term projects as they do not have to repay the principal amount. This provides them with better growth opportunities.
✓ Flexibility to redeem bonds – It provides the issuer with the flexibility to redeem the bonds at their convenience.
Advantages of Perpetual Bonds for Investors
Investing in a perpetual bond has its own set of benefits, such as:
Fixed Income Source
Like any other bond, a perpetual bond attracts investors searching for a reliable fixed-income source. The bond terms, like interest payments and due date, are decided before the release of the bond.
Unlimited Interest Payments
Since perpetual bonds lack any maturity date, they can offer regular coupon payments to investors forever.
Less Risk Investment
Although perpetual bonds have a credit risk, the perils of investing is such securities are less compared to stocks. During a bankruptcy, investors of perpetual bonds take priority over the claims of the shareholders.
How Does a Perpetual Bond work?
The concept of perpetual bonds is simple. These are perpetual debt instruments issued by government institutions or banks for the purpose of raising capital with a fixed interest or coupon rate. Individual investors purchase these bonds to receive a fixed income perpetually, i.e., till the issuer decides to redeem the bonds. In these types of bonds, the issuer is not required to repay the principal amount. Although perpetual bonds are a risk-free investment, they still carry a credit risk for the investors. Moreover, there is a risk of the investor losing the investment value if the market interest rate becomes more than the bond’s coupon rate. To counter this risk, some issuers may offer to increase the coupon rate after a fixed number of years, depending on the market rates.
Although perpetual bonds are very different from equity in various aspects, they still resemble equity more than debt. Therefore, they are considered to be a part of equity. It is important to note that the issuer has an option to redeem the bonds after the specified time has passed. This provides the issuer with the flexibility to redeem the bonds at their convenience, making it the most sought-after option to raise finance for the issuer.
The yield of a perpetual bond on the current date can be calculated by dividing the annual coupon payment by the market price of the bond. Further, multiply the figure with 100 to express it in terms of percentage.
Here is an example –
For instance, you purchased an Rs.1000 bond at a discounted rate of Rs. 850. The annual interest income received on the bond is Rs. 80. Then, the yield will be calculated as follows –
(80/850)*100 = 9.41%
Why are Perpetual Bonds for you?
As an investor, you must be wondering why you should invest in perpetual bonds over other bonds. Here are a few reasons why perpetual bonds are your best bet –
✓ Fixed source of Income – Perpetual bonds provide you with a perpetual fixed source of income that will get credited to your bank account annually.
✓ Higher Yield – Perpetual bonds are issued by large governmental corporations or banks and therefore have a higher yield.
✓ Ease of Investment – Yubi provides you with a unified marketplace to explore and invest in any bond. You can compare the interest rates and the history of each bond through this platform.
Calculating the Yield on a Perpetual Bond
Investors can determine the yield to understand what to expect from a perpetual bond:
The yield on a perpetual bond = Periodic Coupon Payment/ Market Price of a bond.
Here is an example for a better understanding. You have spent money on a perpetual bond with a par value of 2000 by buying the bond at a rebate of Rs. 1950. You get coupon payments of Rs. 90 each year.
Current Yield = 90/1950 *100
= 0.046 *100
The current yield of the bond is 4.6%.
How to Calculate Perpetual Bond Value?
The accounting principle, ‘Going Concern’, is relevant here. It sets the basis for the organisation to pay dividends forever. This theory is the basis of the Dividend Discount Model. The formula is similar to the Dividend Discount Model.
Here is a brief overview of the formula for perpetual bond value.
Formula & Derivation
Mathematically, the present value of a perpetual bond can be written as:
Here, A = Coupon Payment
K = Discount Rate relevant for the bond
Perpetual Bond Duration
The period of a bond determines the sensitivity of the price of a bond in regard to the changes in the principal interest rates. The formula to determine the duration of a perpetual bond is (1+ Yield)/ Yield.
Yes, the issuer can redeem perpetual bonds when the interest rates start declining, giving the issuer a chance to refinance at a lower rate. However, they usually have a lock-in period of 5-10 years.
The annual income from the perpetual bonds in India is included in the annual income of the investor and taxed as per the applicable slab rates.
Although these bonds create a perpetual debt for the issuer, unlike debt, these bonds do not have to be repaid. Therefore, they are considered to be a part of equity.
No. Perpetual Bonds do not have any maturity date.
A perpetual bond is issued to raise funds or capital. Such capital is deemed to be equity since it has no maturity.
Perpetual bonds have interest rate risk, credit risk, and liquidity risk.
Such bonds are listed on stock exchange in India.
Yes. You can sell your perpetual bonds on a stock exchange.
Using a professional online platform to invest in bonds is always recommended. Yubi is recommended for the several benefits it offers to its potential investors and users.
Yes. Such bonds offer high-interest rates compared to fixed deposits.
Such bonds have no maturity date.