What is a Perpetual Bond?

What is a perpetual bond?

Perpetual bonds - referred to in the market as perps, are bonds that exist to perpetuity. In other words, they have no maturity date. Governments, banks and companies that issue them contract to pay interest to investors forever. By the same token, since they never mature, issuers never have to pay investors back their principal.

Why does a perpetual bond exist?

For issuers, perps have significant balance-sheet benefits. For investors, perps offer higher returns relative to standard forms of debt.

How are perpetual bonds like equity?

The best way of thinking about perpetual bonds is as bond-like hybrid instruments that have equity-like characteristics.

Why do companies issue perpetual bonds?

Gaining partial equity credit by issuing perpetuals and other kinds of ultra long-dated hybrid debt helps companies lower their debt leverage, which helps companies raise more cost-effective finance in the capital markets and boost their credit ratings.

Other benefits include:

1. Companies will often use perpetuals as part of acquisition financing packages because it makes acquirers’ balance sheets look more robust at a critical time
2. Companies in the telecommunications, utilities, infrastructure, energy and real estate sectors, issue perpetuals as they have long-term projects to finance
3. Perpetuals are classified as debt instruments, and interest payments are tax deductible

Why do people invest in perpetual bonds?

Perpetuals are popular on the buy side with insurance companies and pension fund managers, who need long-dated, fixed-rate assets to match their long-term liabilities. More generally, they are attractive to credit investors, particularly during a period of lower interest rates as they offer higher yields relative to other forms of debt.

What are the risks associated with perpetual bonds?

Perpetuals come with risks, which counterbalance the higher returns. Some of these risks include:

1. Investors in perps are exposed to the credit risk of the issuer
2. Perpetual bonds are classified as deeply subordinated instruments
3. Liquidity risk due to the limited trading market for these instruments
4. Sensitive to changes in interest rates
5. Call risk (if the issuer chooses to buy back the bonds, the investor is faced with having to re-invest the money in similar products that may offer lower yields)

What are the unique features associated with bank perpetuals?

Unlike corporate hybrids, bank perpetuals have a unique additional set of features: if a bank’s core capital ratio falls below a set level (usually 5-1/8%), Contingent Convertible (CoCos) or Additional Tier 1 bonds (AT1s) can be converted into common equity, or their value can be permanently written down.

Also, whereas features such as coupon deferral and bond calls in the corporate segment are largely a matter for the company’s executive team, in the bank segment, the regulator can intervene.