What is a Perpetual Bond?
Perpetual bond refers to a bond without an expiration date. It is a fixed income financial instrument with no maturity date; hence it offers interest income to the instrument holder for an indefinite period. It is also known as “perps” or “consol bonds.”
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Consol bonds, typically issued by governments, qualified banks, and public companies, first appeared in Britain. The Beinecke Rare Book & Manuscript Library at Yale University holds a perp issued by the Dutch water authority Stichtse Rijnlanden in the 17th century and still receives interest income and serves as one of the oldest examples.
Key Takeaways
- Perpetual bond refers to the bonds with no maturity date. They are also known as “perps” or “consol bonds.”
- They are fixed-income securities that deliver a perpetual flow of interest income to their holders. Also, the issuers usually do not repay the principal, and it is legally acceptable.
- It possesses the features of both equity and debt instrument. For example, there is no stock dilution hence resembling the debt financing, and no principal repayment required, similar to equity financing.
- A perp issued by the Dutch water authority Stichtse Rijnlanden in the 17th century is one of the oldest examples.
Perpetual Bond Explained
A perpetual bond will not reach maturity or expire, and its holder can experience the interminable flow of income in a low-risk environment. It presents benefits to its issuers also. The issuers collect a lot of funds at the time of issue and do not hold the liability to repay the principal. It helps companies obtain optimal capital structures, save costs, and reduce financial risk. In a nutshell, it provides a good choice for satisfying the financing needs of the entities.
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The method of raising capital by issuing a consol bond possesses the features of both equity and debt financing. It is a fixed income financial instrument providing its holders with periodic fixed interest income and no stock dilution resembling debt financing. At the same time, its issuers are not liable to pay back the principal at any point in the future, like in the case of equity financing. Furthermore, it is typically treated as an equity form of financing, thereby reducing the debt ratio.
There are some exceptions sometimes. For example, issuers enjoy a call option and redeem the consol bond issued. Also, if the issuer entity goes into liquidation, they will settle the consol bond investors after all other creditors but before settling preference and equity shareholders. Another finding is that sometimes a bond with a maturity period higher than 30 years is also tagged as a perp or consol bond. Furthermore, consol bondholders also face risks like interest rate risk and credit risk.
One of the most prominent perpetual bonds in India is termed Additional Tier 1 or AT-1 bonds and is created by banks to meet their Basel III capital requirements. It illustrates a potential risk scenario. If banks run out of capital or face bankruptcy, they can write off the principle and not pay interest on bank AT-1 bonds.
Formula
The current yield and present value of the perpetual bond formula are as follows:
Where:
- D – Periodic coupon payment or fixed interest income
- r – Discount rate
The concepts like the time value of money impact the perpetual bond valuation model. Extracting the investors’ real value of interest income obtained from consol bonds depends on applying the present value concept. Hence the perpetual bond price is presented as the present value of the fixed interest income or the periodic coupon payment (D), dividing D by the discount rate, r.
Example
Perpetual bond examples are always discernable from the effort of an entity or a nation to recover from debt accumulation or other financial crises. For example, the history of issuance of consol in Britain is traced back to 1752, then again as an attempt to finance the Napoleonic and Crimean Wars, the Slavery Abolition Act, the Irish Distress Loan, and World War I. When Winston Churchill was Chancellor, he issued “4% Consols” in 1927, mainly to refinance bonds from the First World War. Also, in 1870 the US Congress authorized its issuance to consolidate the debts accumulated in the Civil War.
In 2020, the consol bonds were again gaining importance as an instrument to combat the issue brought by pandemic waves. For example, Spain anticipated the introduction of the EU’s issuance of consol and perceived it as an effective measure since it provides necessary financial resources.
Frequently Asked Questions (FAQs)
Perps are not a high-risk investment. However, investors may face the impact of the issuer’s credit risk. Moreover, the probability of interest rate risk and liquidity risk are perceptible. For example, the issuer can refinance the issue to get a favorable interest rate, affecting investors. Also, if the issuer is going into liquidation, they can write off the principle and not pay interest.
Companies issue bonds with no maturity date to raise capital. Since it possesses no maturity date and issuers are not legally liable to pay back the principal, they are treated as equity financing. Hence, it is evident that it reduces the debt leverage or the debt portion of capital structure and possesses a non-dilutive feature.
Perps are fixed-income bonds with no maturity date. Hence it comes with an indefinite life and no maturity value. Sometimes, a bond with a maturity date higher than 30 years is called a “consol.”
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This has been a Guide to What is Perpetual Bond. Here we explain the perpetual bond formula, duration, valuation, price, and examples from Europe & India. You may also have a look at the following articles to learn more –
- Series I Bond
- Series EE Bond
- War Bond
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
