There are several investment options where you can put your money depending on the return potential, level of risk and investment horizon. Bonds are one of the most popular investment alternatives due to the secured returns it offers over a period of time.
Perpetual bonds are a type of bond that does not come with any maturity date. The issuers are responsible for paying a steady amount of interest till they decide to call the bonds back. It does not provide a redemption option to the bondholders.
Let’s see the different operational dimensions of these bonds in greater detail!
What Are Perpetual Bonds?
As the name suggests, these bonds are perpetual in nature, i.e., they do not have an end date. There is a regular interest payment that you, as a bondholder, will receive from the issuers. However, there is no concept of any principal payment on redemption.
Usually, bond issuers have the option of calling back these debt instruments as per the terms and conditions mentioned in the bond offer document. The calling back timeline varies from one institution to another, but generally, it is in the range of 5– 10 years.
Now that you are aware of the meaning of perpetual bonds, let’s shift our focus to its other working aspects.
How Do Perpetual Bonds Work?
These debt instruments operate as a fixed income security with no set maturity date. These bonds are a kind of debt obligation, but in reality, obligation is not mandatory. In case Issuers incur loss for any year, they may decide not to pay the interest to such bond holders.
These comprise only a small percentage of total outstanding bonds in the market since there are very few entities that are considered to be reliable enough to issue such bonds.
These bonds were issued for the first time by the British Government to fund its wartime expenses during World War 1. In India, these bonds are listed on various stock exchanges. Hence, you can exit these bonds by selling them on the stock exchange.
Why Do Entities Issue Perpetual Bonds?
Generally, banks and other financial institutions issue these bonds in order to fulfill their capital adequacy ratio requirements as per the Basel III norms. A higher capital requirement was seen as a necessity after the grave financial crisis of 2008.
As per the Basel III requirements, banks must maintain a capital adequacy ratio of 10.875% to insulate themselves against various shocks. Moreover, as per regulations of the Reserve Bank of India, banks can choose to skip regular interest payments of perpetual bonds in case their capital drops below a particular threshold.
Moreover, banks can choose to call back or redeem these bonds if they find other financing options at a lower cost. It might be the case if the interest rates are falling in the medium to long term.
What Are the Features of Perpetual Bonds?
Some features of perpetual bonds are as follows:
- Even though issuers of such bonds have high creditworthiness, they can skip payments of interest due to capital falling below required levels. This makes this instrument a risky option.
- These bonds come with a fixed income that banks shall pay to bondholders till redemption, except in exceptional circumstances.
- As the risk level is high in these instruments, they offer a higher interest rate than other bonds of similar category, like government bonds.
- In case the Issuer winds up, the investors in perpetual bonds will be paid last but before equity.
- These bonds are listed on various stock exchanges in India.
What Are Advantages of Investing in Perpetual Bonds?
Here are some advantages of investing in perpetual bonds:
- Fixed income option
These bonds serve as a source of fixed income for their investors. As it does not have any maturity date, interest income from perpetual bonds is recurring or evergreen in nature. A continuous flow of income helps in realising investment goals in a more efficient manner.
- Higher yields
Traditionally a perpetual bond comes with a higher yield than any normal bond. A high return potential makes it an ideal investment objective since, return or income is the foremost factor that one considers while making any investment decision.
- Low risk
Perpetual bondholders are given preference while settlement of dues at the time of liquidation. They are at a lower risk than shareholders of losing their money if the company goes bankrupt. Perpetual bonds are secured assets with a low default risk as securities in which they put the money is of high credit ratings.
Drawbacks of Investing in Perpetual Bonds
Although perpetual bonds provide several benefits to its investors, it also has some cons that they should keep in mind before investing in it. Some of the drawbacks are discussed below:
- Call option
Although they are called perpetual bonds, it does not mean that they will run till eternity. Every such bond has a call or redeemable feature that allows bond issuers to redeem these bonds after passage of a certain time period. This call feature is unilateral as bond holders do not have any say or cannot do anything to stop bond holders from exercising it.
- Inflation risk
Every investment has some sort of inflation risk and perpetual bonds are no different in that aspect. This risk becomes active when the rate of inflation is higher than the rate of return. It reduces the real rate of return and degrades the purchasing power of your investments.
- Interest rate risk
This bond also suffers from respective interest rate risks. The market interest rate will rise during inflation as central banks will be increasing their benchmark lending rates. A rise in interest rate will lead to a commensurate decline in bond prices. If bond issuers exercise the call option this time, bondholders will receive a lower price for their bonds and incur some losses.
How is the yield of perpetual bonds calculated?
Let’s consider an example of a perpetual bond to provide you with an idea about the yield that they offer. It will help you get a better grip of the concept.
Here’s how you can calculate the potential returns of a perpetual bond.
Present market yield of a perpetual bond = Regular coupon payment/Bond’s market price
Suppose you have invested in a perpetual bond which has a face value of ₹10,000. However, this bond has come with a discount of ₹500, and therefore, the purchase price stands at ₹9,500. The regular interest payment amounts to ₹550 per year.
Therefore, the current yield is: (550/9500)*100
Therefore, we can see that the yield that you will be getting is 5.78%.
Who Should Invest in Perpetual Bonds?
These bonds can be ideal for you if you are a retired investor looking for a decent regular stream of income to finance your post-retirement life. However, as the risk quotient in these bonds is a bit high, it is important for you to consider your risk appetite before investing. As it comes with a high-risk band, make sure that these bonds align with your investment goals.
Perpetual bonds represent only a small percentage of the overall outstanding bond in the market in terms of volume. This is because of the high risk and low demand associated with these instruments. If you are looking to invest in these bonds, it is imperative that you conduct a thorough market analysis and consider different aspects like taxation and return before investing.
Frequently Asked Questions?
Q1. Who can issue perpetual bonds in India?
Ans. Only government entities and banks in India can issue these bonds to investors. The majority of the bond issue is done by banks to cover their capital requirements.
Q2. What are the benefits of a perpetual bond?
Ans. The major benefit of investing in perpetual bonds is fixed regular interest payments that serve as a fixed source of income. Moreover, interest payment is perpetual, i.e., it continues without any maturity date.
The interest earned from perpetual bonds is added to the gross total income of respective bondholders. Therefore, interest income of perpetual bonds is subject to taxation as per the tax slab of the bondholder.
Q3. How are perpetual bonds taxed?
Ans. If you sell them in secondary markets, all gains shall be subject to taxation as per capital gains tax. If the holding period is less than 12 months, the income generated will be taxed as per your applicable tax slab rate. If the holding period is 12 months or more, long-term capital gains tax will be applicable. The rate of long-term capital gains tax is 10% without indexation.
Q4. What are the risks associated with perpetual bonds?Ans. Perpetual bonds primarily suffer from two types of risks – interest rate and credit default risk. Out of these two, the interest rate risk can vary as per the prevailing macroeconomic conditions of the country.
Anuj is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.Com (Hons) in St. Xavier’s College, Kolkata and holds PGDM (Finance) degree from GIM. He is currently working as Investments Principal at Wint Wealth. He has been working in the debt capital market space for the past 4+ years and is also an NISM certified mutual fund expert.