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Understanding the basics of perpetual bonds

08 Feb 2024

Introduction:

If you are into short-term savings or prefer a low-risk approach to investing, debt options can be your go-to. Among the various fixed-income assets, perpetual bonds can be a viable choice. However, before diving into this investment avenue, it is essential to grasp its basics. This article will break down perpetual bonds and explore what makes them unique. Read on to find out if they are the right fit for your portfolio.

What is a perpetual bond?

A perpetual bond, often called perps or consol bonds, is a type of bond without a maturity date. Unlike regular bonds that repay the principal amount when they mature, perpetual bonds continue paying interest indefinitely. These fixed-income securities lack a set maturity date. 

The current yield on a perpetual bond is determined by the relationship between its periodic coupon payments and the fair market value of the bond. You can calculate the yield using the following formula:

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Current yield = Periodic coupon payment/ Market price of the bond * 100

While perpetual bonds are generally considered a safe investment, they expose you to the credit risk of the issuer for an indefinite period. This makes it crucial for you to assess the financial stability of the issuing entity carefully.

How do perpetual bonds work?

Perpetual bonds allow issuers to raise capital through fixed interest or coupon rates. You can purchase these bonds and receive a steady income. Unlike traditional bonds, perpetual bonds do not have a maturity date, and the issuer is not obligated to repay the principal unless they choose to redeem the bond using the call option.  

Perpetual bonds carry some risk. In fact, they share some similarities with equity instruments that pay consistent dividends but do not grant any voting rights to the issuing entity in the decision-making process. Additionally, while providing a fixed income stream, perpetual bonds bring an element of interest rate risk that you need to consider in your investment strategy. These bonds are susceptible to changes in interest rates in the open market. If the market interest rate surpasses the bond's coupon rate, the investment value of perpetual bonds may decrease.

Government entities and banks primarily issue perpetual bonds to raise capital. Banks, in particular, use perpetual bonds to fulfil their long-term capital needs, considering them as Additional Tier I instruments with quasi-equity characteristics. In the event of liquidation, perpetual bondholders are prioritised before equity shareholders in the payment sequence. Notably, the coupon payment for perpetual bonds in a given year depends on the bank's profitability. In cases where a bank is incurring losses or fails to meet the government's minimum adequacy requirement, it has the discretion to opt not to pay interest for that financial year.

Benefits of investing in perpetual bonds

Investing in perpetual bonds offers several benefits:

  • Perpetual bonds provide a dependable source of regular fixed income. This makes them attractive if you seek income stability over an extended period. They can be particularly beneficial for retirees.
  • Perpetual bonds are generally considered safe instruments with minimal exposure to market risks. This makes them well-suited for risk-averse investors. However, despite their safety, it is essential to thoroughly analyse the issuer's creditworthiness and financial stability before making an investment decision.
  • Issuers often offer higher interest rates on perpetual bonds than bonds with fixed maturity dates. In India, the yield on perpetual bonds tends to be 200-300 basis points higher than government bond yields. This makes them an excellent proposition for earning enhanced returns.
  • Unlike bonds with fixed maturity dates, perpetual bonds eliminate reinvestment risk. You do not have to look for alternative investment options when the bond matures.

Disadvantages of investing in perpetual bonds

Perpetual bonds come with the following disadvantages:

  • Perpetual bonds expose you to the credit risk of the issuer. If the issuer's creditworthiness deteriorates, you may not receive timely interest payments.
  • Perpetual bonds are susceptible to interest rate risk. These bonds become less attractive in a rising interest rate environment, and their market value may decrease.

To sum it up

Perpetual bonds offer a unique avenue for risk-averse investors. They provide financial stability and regular income. However, while they come with benefits like fixed income and safety, it is important to consider the issuer’s creditworthiness carefully. Understanding how perpetual bonds work and the risk involved with the issuer is key to making informed investment decisions about investing in this distinct financial instrument.

 

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