A perpetual bond is a special kind of bond that does not have to be
paid back by the person who borrowed the money. This means that the
only compensation a bondholder has is the interest he receives;
there is no right for payback of the principal. We'll take a look at the
risks and benefits of having such bonds for both the
issuer and the person buying them - infinity is a long time. A word of
warning: it is said bond people are a lot smarter than stock people.
This writeup, unfortunately, seems to provide evidence for this.
Anyway, the main advantage for the issuer is that capital that it
doesn't have to pay back is considered equity, and can be
leveraged. This is of great value, as it allows a company to have a
bigger operation without having to raise equity by issuing stock.
Issuing stock would dilute the value of stock held by current
investors. The main disadvantage is that payment of the interest is
mandatory, whereas a company doesn't have to pay a dividend. However, in
some bonds, the company can defer the payment of the interest
when it doesn't pay a dividend. It's like stock, only it doesn't carry
A second major advantage is the fact that most of these issues offer the
right, but not the obligation, for the company to redeem the bond, by
paying it back. In other words, the company has a call warrant on the
bond, and the owner of the bond is short that warrant. The terms for
this call vary; often, it may only be exercised in a few years,
and then for instance once a year. The company might exercise this call if
it can find cheaper money elsewhere - perhaps a regular bond, or a
perpetual bond with a lower interest rate. Of course, it doesn't have to
do this; if the current arrangement is cheaper, it will
just keep it. In practice, this means the company will redeem when interest
goes down, and will keep the bond when it goes up.
So, in other words, the person buying this bond doesn't know when
he will get his money back and isn't even sure of an interest payment if
it's linked to the dividend. Worse, the investor is pretty much
guaranteed that he will get his money back when interest is lower, so he
won't be making as much as he would have when holding the bond. If the
interest were to skyrocket, the investor would rather have the money and
invest it somewhere else where it would yield even more interest. So, why
would anyone buy this faux stock?
The reason is interest. The interest on these products is often very
high for several reasons:
- The duration is long. Long-dated bonds are much more risky than
short-dated bonds; this is reflected in a higher interest rate.
- The interest a company has to pay is higher that a government has to
pay, because the company can default. This effect is amplified by the long
duration of the bond, especially for a company that might be quite solvent
now, but may not be in a decade or two.
- The call option the issuer has is valuable, and the investor has to be
- Often, these bonds are subordinated. This means that should the
company default, other bondholders get paid first. In practice, this more
likely than not means that a default means your entire investment is
For products such as these, receiving 2-3% more interest than a 10-year
bond is probably the lower limit an investor
The payment should initially never be less than the dividend, either, as the
dividend should go up in the long run, while the interest
Often, these products are tradable. It is worth noting that in this
case, the interest is computed over the value of the principal, not the
price one pays. For instance, imagine a perpetual 8% bond is trading at 70
euros with a principal of 100 euros. In this case, 1000 euros buys roughly
14 bonds, which pay 1400 * 8% = 112 euros of interest, or 11.2%. Should the
company decide to pay back its bonds, it will pay 1400 euros, making the
investor another 40%.
As discussed, this product is rather risky for an investor to
hold. The main risks are:
- Market risk. The price of the bond can fluctuate in the market. If
the investor is under no pressure to sell, this in itself doesn't really
matter, as the interest stream doesn't change.
- Market risk for an interest rate increase. If the interest rate goes
up, it would be relatively better to invest in other bonds. This will
manifest in the price of the bond. If you are a private investor, you
will probably find this a bit annoying; for a professional player who may
have bought the bond with borrowed money, the immediate loss in the bond
price hurts. As a very rough rule of thumb, a percentage point of interest
rate increase may depress the value of the bond by about 5 to 10% (although
I can think of many exceptions).
- Market risk for an interest rate decrease. This will move up the price
of the bond-by just a little. While the perpetual bond becomes a better
investment relative to other bonds, leading to a price increase, the effect
is minor as it becomes very likely the issuer will redeem the bond.
- Default risk. If the market thinks the issuer will default, the value
of the perpetual bond will drop very fast. Of course, if the company
actually defaults, the entire investment is gone.
As one can see, there are many reasons for the price of the bond to go down,
while there is very limited potential for it to go up. This is compensated
for by the high fixed return
. In fact, for modest price drops, say caused
a 1% increase in interest rate, this return
is so high that the investor
is still breaking even.
In summary, a perpetual bond is a bond that doesn't have to paid back by
the issuer, but does pay a fixed interest. In this, it is a bit like a
share and a bit like a normal bond. Its risk is between that of a
share and a normal bond. As it is a fairly complex product with a pretty
asymmetric risk profile, it's best for advanced investors.