Perpetual Bonds

Quick Answer: Perpetual bonds are a type of fixed-income security with no maturity date, meaning the bond issuer is not required to repay the principal amount. Instead, the issuer pays the bondholder a fixed interest payment indefinitely. Perpetual bonds provide the issuer with permanent capital while giving investors a steady income stream without an end date.

Features

Typical bonds issued by governments and corporations function like loans: investor capital (called the principal) is given to the issuer upfront in exchange for periodic coupon payments during the bond's term. Once the bond reaches maturity, the coupon payments cease, and the issuer repays the principal to the investor.

Perpetual bonds have no maturity date, and the coupon payments continue indefinitely. The issuer is not obligated to return the principal to investors but must continue paying interest on the bond in perpetuity. Investors get steady long-term income, while issuers receive a capital infusion they don’t need to repay.

However, many perpetuals come with a call provision, which means the issuer can redeem the bond at a future date if certain conditions are met, such as a decline in interest rates. Review the prospectus and understand any call provisions on the bond before buying.

Types

Perpetual bonds have no term and are a long-term investment for steady income. Corporate and government perpetual bonds work straightforwardly; the issuer keeps the principal and pays interest to investors unless the bond is called.

However, some hybrid types also exist since perpetual bonds have similar qualities to equity and debt. One example is the Contingent Convertible Bond, which can be converted to stock should the issuing company face a capital crunch. Hybrids can have a unique and unusual structure, so carefully research these instruments and understand all the terms.

Issuers 

Perpetual bonds are issued by corporate or government entities seeking alternative capital-raising mechanisms to traditional equity or debt mechanisms. However, these bonds aren’t frequently used and tracking down prices or issuers can be difficult. Perpetual bonds have unique risks and can be challenging to manage when interest rates and economic activity fluctuate.

One historical perpetual government bond example is the consols issued by the U.S. Treasury from 1877 to 1930. Short for ‘consolidated annuity,’ consols were designed to reduce and simplify government borrowing expenditures. Consols no longer exist, though; all have been redeemed.

Valuations

Bond valuation comes primarily from three different approaches:

• Yield-to-Maturity 
• Discounted Cash Flow Analysis
• Relative Valuation

Each method has its strengths and weaknesses, but since perpetual bonds don’t function like traditional bonds, some assumptions must be made during the valuation process.

For a yield-to-maturity approach, perpetual bonds throw a wrench in the gears - there is no maturity date! The traditional YTM calculation uses the present value of all future coupon payments and the current market price of the bond to get an internal rate of return (IRR). But without a maturity date, it’s impossible to accurately value perpetuals using YTM.

The DCF analysis also calculates the present value of future coupon payments but can be tweaked to add a growth rate assumption to account for indefinite coupons. The DCF method requires accurately projecting two variables: the assumed growth rate and the IRR.

Finally, the relative valuation method involves looking for similar-structured bonds to form a benchmark. For example, bonds from the same issuer (or issuers with similar credit risk) can be used to analyze the value of newer bonds.

Risks

• Interest rate risk: Since the term is indefinite, perpetual bonds are constantly exposed to interest rate risk. Rates will inevitably change during the bond's lifetime, which could cause price volatility.

• Reinvestment risk: Perpetual bonds pay coupons to investors, but since there is no guarantee of principal return, coupons are the only return. Investors who wish to reinvest these coupons must find a higher rate of return than their coupon rate, which can be difficult in specific market environments.

• Liquidity risk: Selling perpetual bonds on the secondary market can be tricky since very few are issued. Additionally, perpetuals fit a unique type of investment plan, so low demand for these instruments may prevent you from selling should you need to raise cash quickly.

• Issuer default risk: Finally, since perpetual bonds are a rare and alternative financing option, it’s imperative to research the underlying fundamentals of the issuers. If the bond issuer defaults, the coupon payments will stop, and you may not get your principal back if company assets are liquidated.

Advantages

• Stable income stream: Perpetual bond buyers are looking for steady and consistent income, usually at a higher rate than they’d get from a savings account or traditional fixed-income financial instrument.

• Hedge against inflation: Many perpetual bonds carry conditional coupon payment increases, which bump up the bond’s interest rates based on metrics like inflation. If inflation rises, the bond interest rate increases will preserve your purchasing power.

• Diversification benefits: Perpetual bonds share characteristics with equities like preferred stock and debt instruments like bonds, making them unique assets in any portfolio. Pursuing perpetual bonds might be a consideration if you want to diversify away from traditional bonds and stock markets.

Disadvantages

• Potential Callability: Some perpetual bonds lack redemption provisions and can trade indefinitely, but these are rare. Most perpetual bonds carry conditions where the issuer can call them back to prevent significant losses.

• Issuer Solvency: Perpetual bonds trade indefinitely until they don’t. If the bond issuer runs into financial difficulty, it may be unable to pay coupons. And if the issuer becomes insolvent, investors may not get their principal back either.

• Limited Secondary Market Liquidity: Traditional government and corporate bonds can be easily purchased on the secondary market or through vehicles like ETFs or mutual funds, which can provide exposure on a broad or narrow scale. Perpetual bonds are more difficult to buy and sell on the secondary market, and there’s no centralized mechanism for listing prices and availability.

Pricing

The simplified DCF formula for the price of a perpetual bond looks like this:

Bond price = Interest payment / Discount rate 

The annual coupon payment is divided by the expected rate of return to find the bond value. For example, if a perpetual bond pays $5,000 in interest annually and the expected discount rate is 5%, the bond's value is $100,000 according to the DCF method.

An additional variable is used in the Gordon Method of DCF analysis. The formula is the same as above, except the coupon growth rate is first subtracted from the discount rate. The Gordon formula goes:

Bond price = Interest payment / (Discount rate - Expected interest growth rate)

The Gordon Method is often used in stock valuations by factoring in dividend growth rates, but since perpetual bonds carry an indefinite and predictable coupon payment schedule, this technique is also helpful in perpetual bond pricing.

Regulatory Considerations

Perpetual bond issuers tend to be large banks, governments, or municipal institutions, so regulatory considerations involve two standards for banking and insurance firms:

1. Basel III Capital Requirements
2. Solvency II Directive

When you hear about bank stress tests, Basel III capital requirements are the regulations in motion. These rules state the amount of capital banks must maintain as a percentage of assets and the liquidity requirements for short-term funding.

Solvency II is a European Union regulation governing insurance issuers' capital requirements and liquidity levels. Like Basel III, these laws dictate how much cash insurers must keep relative to assets and require participants to conduct internal stress tests.

Investment Strategies

• Income-oriented portfolios: Assets designed to produce income, such as dividend stocks, preferred stocks, government and corporate bonds, and annuities, can be supplemented by alternative debt assets like perpetual bonds.

• Total return portfolios: These portfolios are designed for a mix of growth and income. Perpetual bonds can be added to a mix of growth stocks, REITs, and other assets across various allocations and timelines.

• Liability-driven investing: Used by institutions, liability investing means matching long-term liabilities with assets paying a similar rate of return. Institutions do this to hedge against risks like inflation or interest rates. 

Market Overview

Juhding the size and scope of the perpetual bond market is difficult since there’s no centralized resource for listings, and the amount of these asses in circulations has steadily dwindled over the last few decades. To find perpetual bond listings, contact your broker or other investment banks to see if they offer any. Also, consider searching for financial analysis services that cover obscure assets like perpetual bonds.

Frequently Asked Questions