The bond market and the equity market are distinct market segments that have vastly different characteristics. However, there is one instrument that seamlessly blends the features of these two types of securities — the perpetual bond. Want to find out if this is a suitable investment avenue for your portfolio? To find the answer, you need to understand the meaning of a perpetual bond and how it works.
What is a perpetual bond
A perpetual bond is a type of debt instrument that has no maturity date. The issuing entity pays out interest on the bond value according to a predetermined rate of interest. Since there is no maturity date, a perpetual bond is not redeemable. So, you continue to receive coupon payments on this security for the foreseeable future.
In this regard, a perpetual bond resembles an equity share because the latter is also not redeemable. The coupon payments from the bond are comparable with the dividend payouts on equity shares, although the former is guaranteed while the latter is not.
Features of perpetual bonds
Perpetual bonds work much like regular bonds, except that they do not have a maturity date. Due to this defining feature, perpetual bonds have certain distinct characteristics, as outlined below.
- Infinite coupon payments: Perpetual bonds offer the advantage of infinite coupon payments. As long as you hold the bond, you will continue to receive interest on your investments without any exception.
- Embedded call option: Since they do not have any maturity date, most perpetual bonds come with an embedded call option that the issuer can exercise. It promotes liquidity and allows the issuer to redeem the bonds at a predetermined date.
- No Yield to Maturity (YTM): This is essentially the yield or return you can expect to earn if you hold the bond till maturity. However, since a perpetual bond does not have a maturity date, it does not have YTM either.
- No return of the principal: The lack of a redemption facility means that investors will never receive the principal amount invested. For most investors, this is a huge risk that can only be set off by long-term and consistent coupon payments.
How to calculate the price of a perpetual bond
The price of a perpetual bond must reflect its strengths and limitations. On the upside, the interest payments are practically infinite. However, on the flip side, there is no return of the principal amount. So, the formula for calculating the price of a perpetual bond only takes into account the coupon payments.
Despite the absence of a maturity date, it is possible to determine the price of a perpetual bond. To do this, you essentially apply a discount rate to all future coupon payments to arrive at the present value of the bond. The formula for this is as follows:
Present value of a perpetual bond = Periodic annual coupon payment ÷ Discount rate
Let us look at an example of perpetual bond value calculation for more clarity. Say you receive Rs. 20,000 as interest from the bond each year. Using an appropriate discount rate of, say 4%, you can calculate the price of the perpetual bond as shown below:
Present value of the bond (aka its price):
= Periodic annual coupon payment ÷ Discount rate
= Rs. 20,000 ÷ 4%
= Rs. 5,00,000
How to calculate the yield of a perpetual bond
While there is no YTM for perpetual bonds, these instruments do have a current yield value. This yield from a perpetual bond can be calculated using the following formula:
Current yield from a perpetual bond = (Annual coupon payment ÷ Price of the bond) x 100
The benefits of perpetual bonds for investors
Like every other investment avenue, perpetual bonds have many benefits to offer investors despite their few limitations. The top advantages of investing in a perpetual bond include the following:
- Reliable income: One of the most preferred benefits of perpetual bonds is that they offer guaranteed income for as long as you hold the instrument. This is useful if you want a reliable source of alternative or additional income.
- No market-linked risk: Since perpetual bonds are essentially debt instruments, they do not carry any market-linked risk. That said, they may carry interest rate risks that you need to factor into your investment decision.
- Higher yields: Another benefit of perpetual bonds is that they typically offer higher yields or coupon payments. This helps compensate for the limitation of not being able to redeem the bond at all.
Conclusion
This sums up the key aspects of perpetual bonds that you must be aware of before investing in such a security. If you do decide to invest in a perpetual bond, ensure that the issuing entity has a high credit rating. The higher the creditworthiness, the more certain you can be of receiving regular coupon payments. This is particularly important to offset the risk of the bond’s irredeemable nature.
