What are Perpetual Bonds?

What are Perpetual Bonds?

A perpetual bond, also known as a “consol bond” or “prep,” is a fixed income security with no maturity date. This type of bond is often considered a type of equity, rather than debt. One major drawback to these types of bonds is that they are not redeemable. However, the major benefit of them is that they pay a steady stream of interest payments forever.

Perpetual bonds, also known as perps or consol bonds, are bonds with no maturity date.

Although perpetual bonds are not redeemable, they pay a steady stream of interest in forever.

How Does a Perpetual Bond Work?

The concept of perpetual bonds is straightforward. Generally, government institutions or banks issue these bonds for the purpose of raising capital with fixed interest or coupon rates. Investors purchase these bonds to receive fixed income perpetually unless the issuer decides to redeem the bonds. Also, the issuer is not required to repay the principal amount.

Even though perpetual bonds are a safe investment option, they still carry credit risk for investors. There is a risk for investors to lose their investment value if the market interest rates go higher than bond coupon rates. To counter this risk, some issuers may offer higher coupon rates for a fixed number of years, depending on the market rates.

Perpetual bonds are different from equities in various aspects. However, they still resemble equity more than debt. Therefore, they can be considered to be a part of equity. The bond issuer has an option to redeem the bonds after a specific time. This allows the issuer to redeem bonds at their convenience, making it an easy option to raise finance for the issuer. Also, the issuer is not obligated to return the investor’s principal.

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Who Issues Perpetual Bonds?

Perpetuals make up only a very small portion of the total bond market. The primary issuers of perpetual bonds are government entities and banks. Banks issue such bonds as a means of helping them meet their capital requirements – the money received from investors for the bonds qualifies as Tier 1 capital.

Some economists argue that perpetual bonds are an excellent vehicle that financially-stressed governments can use to raise money. However, most classical economists do not approve of governments creating debt that they have no obligation to repay, nor do they consider it sound fiscal policy for a government to take on the contractual responsibility of making payments, to anyone, in perpetuity.

Pros and Cons of Perpetual Bonds

Pros

  • Indefinite interest payments
  • Source of fixed income
  • Low-risk investment

Cons

  • Typically callable
  • Inflation risk
  • Opportunity cost

Pros Explained

  • Indefinite interest payments: Because perpetual bonds have no maturity date, they can theoretically provide investors with regular coupon payments forever.
  • Source of fixed income: Like other types of bonds, perpetual bonds appeal to investors seeking regular fixed income. The terms of the bond, including the amount of interest payments, are determined before the bond is issued.
  • Low-risk investment: While perpetual bonds are subject to credit risk and interest rate risk, the risk of investing is generally lower compared to the risks of stocks. Perpetual bondholders’ claims take precedence over shareholders’ claims in the event of a bankruptcy.

Cons Explained

  • Typically callable: Perpetual bonds generally have a call feature, which allows the issuer to redeem the bond after a certain amount of time has elapsed.
  • Inflation risk: Investing in perpetual bonds carries inflation risk, which is the risk that your investment won’t earn enough to keep up with inflation. When this occurs, your money loses purchasing power.
  • Opportunity cost: When you invest your money in perpetual bonds, there’s an opportunity cost because you could be missing out on potentially more profitable investments.
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Example of a Perpetual Bond

Since perpetual bond payments are similar to stock dividend payments, as they both offer some sort of return for an indefinite period of time, it is logical that they would be priced the same way.

The price of a perpetual bond is, therefore, the fixed interest payment, or coupon amount, divided by some constant discount rate, which represents the speed at which money loses value over time (partly due to inflation).

The discount rate denominator reduces the real value of the nominally fixed coupon amounts over time, eventually making this value equal zero. As such, perpetual bonds, even though they pay interest forever, can be assigned a finite value, which in turn represents their price.

Conclusion

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.