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De-jargoned – Perpetual Bonds

Holding till perpetuity means that you will have to earn the same return even if the overall interest rates in the economy go up

As the name suggests, a perpetual bond exists to perpetuity which means it does not have a fixed tenure and neither does it get redeemed. These bonds are usually used by governments and government-owned entities as they require long-term funding, however, private sector companies use them as well. Unlike regular bonds, these will not get redeemed and will continue to pay interest for an unlimited period. Perpetual bonds are not much favoured due to the risks associated with them. Let us take a closer look at why these bonds are not a much favoured option.

THE PROS AND CONS

Regular bonds have a fixed return and tenure, whereas perpetual bonds can go on forever. While the return is fixed, holding a security till perpetuity comes with uncertainties, which bond holders may not want to take.

There are other risks as well. Holding till perpetuity means that you will have to earn the same return even if the overall interest rates in the economy go up. Moreover, investors have to bear with the credit rating of the issuer for a very long period of time, this can be a matter of concern if financials deteriorate. This is the reason that perpetual bonds are considered to be equity-like securities. In some issuances, there are clauses which allow the bonds to be converted into equity on preset conditions.

Most perpetual bonds also have a call option. This means that the issuing company can call back the bonds or redeem them after a few years. This might happen if interest rates in the economy have fallen substantially from the rate at

which the bonds were issued or it could be that the company is actively restructuring its capital structure. Either way, the option to redeem lies with the issuing company rather than the investor. The benefit of perpetual bonds is that investors get a predictable, steady stream of income.

HOW MARKET YIELDS IMPACT DEMAND

Given that perpetual bonds come with a fixed coupon, typically their demand increases when the interest rates are decreasing.

In a falling rate environment, existing bonds with high coupon rate come in demand as subsequent issuances of bonds fetch a lower coupon for the investor. Bond prices and yields are inversely related which means prices rise when yields move lower.

This renewed demand then pushes up the price and market yields get rationalised. On the other hand, if market rates are on the way up, such bonds don’t find favour with investors.

In the Indian context, issuances in the past few years were seen mainly from public sector banks and a handful of companies. However, these bonds are mostly bought and traded by institutional investors such as provident funds, bank treasuries and large-sized debt managers. Typically, the face value of each bond is set in lakhs hence, it is meant to target only big-ticket investments.

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