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Tata Capital > Blog > Wealth Services > Perpetual Bonds – How Do They Work & Why Banks Issue Them?

Wealth Services

Perpetual Bonds – How Do They Work & Why Banks Issue Them?

Perpetual Bonds – How Do They Work & Why Banks Issue Them?

In the 18th century, the British Government introduced Consol bonds to fund military projects and infrastructure development. "Consol" was short for "consolidated annuities." These bonds had no maturity date and paid annual interest indefinitely. Over time, they evolved into what we now know as 'Perpetual bonds.'

Perpetual bonds are investments without a predetermined end date – the capital invested remains with the issuer indefinitely. Additionally, these bonds provide a continuous stream of interest income, depending on the financial strength of the issuer. So, who issues them, and how do they work? Keep reading to learn all about perpetual bonds in India.

What are perpetual bonds?

Perpetual bonds, meaning a type of fixed-income security with no maturity date, are also known as “perp bonds.” These bonds cannot be redeemed, indicating that the principal amount is not repaid with a specific redemption date. Consequently, the interest payments on perpetual bonds continue indefinitely, or "in perpetuity."

However, these bonds typically come with a call option. This allows the issuer to recall the bond within the specified duration, which is usually five or ten years from the date of issue. When the issuer exercises this option, they recall the bond and repay the principal amount to the investor.

It's worth noting that perpetual bonds are traded on the listed stock exchanges. Therefore, if an investor wishes to sell or liquidate their investment, they can do so by selling the bonds on the stock exchange.

What are the key characteristics of perpetual bonds?

Here are the unique features of perpetual bonds:

1. Perpetual bonds or perpetual securities pay periodic interest to bondholders indefinitely, rather than having a fixed maturity date. The interest rate is typically fixed but can also fluctuate based on benchmark rates.

2. Most perpetual bonds allow the issuer to redeem or "call back" the bonds after a set number of years. This option provides flexibility to the issuer but uncertainty for investors.

3. Investors often look at the yield-to-call to analyze the annual return if the issuer decides to call the bond. It helps assess potential returns and risks.

4. Perpetual bonds have no fixed maturity date. This means the issuer is not legally bound to repay the principal amount of the bond, thus the bonds theoretically last forever.

How do perpetual bonds work?

Financial institutions and governments issue perpetual bonds to secure funding against fixed coupons or interest rates.

Individual investors buy these bonds to receive a continuous fixed income until the issuer decides to redeem the bonds. As such, in perpetual bonds, the issuer is not obligated to repay the principal amount.

While perpetual bonds are generally considered a secure investment, there is a credit risk for bond buyers. Investors may face losses if market interest rates surpass the bond coupon rates. To manage this risk, issuers might offer higher coupon rates for a specific period based on the current market rate.

Despite being different from equity investments, perpetual bonds share more similarities with stocks than with traditional debt instruments, making them a thoughtful and fair investment option.

Why do banks issue them?

Banks issue perpetual bonds to help meet their long-term capital needs. In the capital structure of banks, perpetual bonds are classified as Additional Tier 1 bonds. This implies that in the event of liquidation, banks repay perpetual bondholders after settling other debts but before paying equity investors.

The coupon or regular interest payments that perpetual bondholders receive depend on the profitability of the issuing bank in that year. Banks that issue these bonds need to maintain a minimum capital adequacy ratio - a measure of their financial stability - of 10.875%, which includes a Capital Conservation Buffer of 1.87%.

How to calculate the yield on a perpetual bond?

The yield of a perpetual bond on the current date can be determined by dividing the annual coupon payment by the market price of the bond.

Investors can calculate the yield on a perpetual bond using the following formula:

Yield = (Periodic Coupon Payment/Market Price of the Bond) * 100

Let's say, the face value of a perpetual bond is Rs. 1000, but you purchased it for Rs. 850. The bond pays an annual interest of 7% per annum. Therefore, you will receive a coupon of Rs. 70 (Rs. 1000 * 7%) per year.

The bond's current yield is = 70/850 *100 = 8.23%.

Why should investors invest in perpetual bonds?

Investing in perpetual bonds can provide some key benefits for investors seeking steady income streams. Here are some of the advantages that make perpetual bonds an attractive investment:

1. Steady income stream

Perpetual bonds provide investors with a predictable and steady income stream through fixed-interest payments. This can be particularly appealing for income-focused investors seeking a reliable source of earnings.

2. Higher yields

Perpetual bonds, being riskier compared to regular bonds, present a higher yield potential. As return on investment is a primary consideration, this elevated return makes it an attractive option for investors seeking higher returns, albeit with increased risk.

3. Saves time

Investing in perpetual bonds can save investors time and effort. The absence of maturity dates eliminates the need to closely monitor and evaluate reinvestment options, simplifying the investment process.

4. Taxation on perpetual bonds

Interest earnings and short-term capital gains from perpetual bonds are included in the investor's total income and taxed according to their income tax slab. However, if the investor sells the bond in the secondary market and realizes long-term capital gains (holding the bond for at least one year), a 10% tax without indexation will be levied.

The bottom line

The perpetual nature of these bonds, coupled with the opportunity for regular income, makes them a valuable addition to your investment portfolio. It's essential, however, for investors to conduct thorough research and seek advice from financial experts before making investment decisions.

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