There are multiple investment options available for investors in the market. Investors can choose from different asset markets and invest their capital based on their understanding of risk and expectations of return after a particular time. Debt instruments are among the most popular investments in India. They offer relatively low risk while helping investors earn returns. They make a good addition to all types of portfolios. In this article, we will discuss a specific type of debt instrument perpetual bonds.
What are Perpetual Bonds in India?
As the name suggests, a perpetual bond is a fixed income instruments that is perpetual in nature. In other words, it has no maturity date. Also, these bonds are not redeemable. However, they pay a steady stream of interest payments to the holder, but they do not receive the principal payment with a set redemption date. Therefore, the coupon payments on these bonds are payable forever, i.e. in perpetuity. These bonds are also known as prep bonds.
In India, the issuer of these bonds has the option of calling back the bonds. This means that the buyer cannot sell the bonds to the issuer unless the call option is being exercised. Generally, the call option dates are every 5 to 10 years from the bond issuance date. Moreover, perpetual bonds in India are listed on the stock exchange. Hence, if the investor wants to liquidate, they can sell the bonds on the stock exchange.
How Does a Perpetual Bond Work?
The concept of perpetual bonds is straightforward. Generally, government institutions or banks issue these bonds for the purpose of raising capital with fixed interest or coupon rates. Investors purchase these bonds to receive fixed income perpetually unless the issuer decides to redeem the bonds. Also, the issuer is not required to repay the principal amount.
Even though perpetual bonds are a safe investment option, they still carry credit risk for investors. There is a risk for investors to lose their investment value if the market interest rates go higher than bond coupon rates. To counter this risk, some issuers may offer higher coupon rates for a fixed number of years, depending on the market rates.
Perpetual bonds are different from equities in various aspects. However, they still resemble equity more than debt. Therefore, they can be considered to be a part of equity. The bond issuer has an option to redeem the bonds after a specific time. This allows the issuer to redeem bonds at their convenience, making it an easy option to raise finance for the issuer. Also, the issuer is not obligated to return the investor’s principal.
Yield on Perpetual Bond
Investors can calculate the yield to know what they can expect from the perpetual bond.
The current yield on a perpetual bond = Periodic Coupon Payment / Market Price of Bond
For example, you have invested in a perpetual bond with a par value of Rs.1000 by purchasing the bond at a discount price of Rs.950. You receive coupon payments of Rs.80 every year.
Current Yield = (80/950) * 100
= 0.0842 * 100
The current yield of a bond is 8.42%
Why Do Banks Issue Perpetual Bonds in India?
In India, banks issue perpetual bonds to meet their long term capital requirements. In banks, these bonds come under the Additional Tier I bonds that have similar Quasi Equity features. This means that in the case of liquation, the banks pay the perpetual bondholders last but before equity investors.
The coupon payments for these bonds depend on the issuing bank’s current year profitability. If the bank has no profits or does not satisfy the minimum adequacy requirement laid by RBI, then the bank has an option for not paying interest for that particular year. The minimum capital adequacy ratio that the banks have to maintain is 10.875% and a Capital Conservation Buffer of 1.875%
In February 2017, RBI came with a circular allowing banks to make coupon payments on perpetual bonds from the reserves/ surplus or carried forward profits. This was in favour of investors, which increased the demand for perpetual bonds in India. Moreover, the yield of perpetual bonds is 200-300 basis points higher than the government bonds yields.
Who Should Invest in Perpetual Bonds?
Perpetual bonds are commonly suitable for retired investors who prefer securing a fixed stream of income payments that they can rely on to receive indefinitely. Also, mainly banks or government institutions issue these bonds, they have a higher yield. Even though the yields are attractive, investors must also look at the taxation perspective. In simple words, the post-tax interest is what remains.
Investing in perpetual bonds reduces the time and effort to find a new bond investment when the current bond matures. However, investors are exposed to credit risk and interest rate risk. If the interest rate rises above the perpetual coupon rate, the investment will lose value. Sometimes, the issuer may offer a step-up feature to increase the coupon rate as per the set schedule to mitigate the risk.
Ultimately, investors can choose to invest in a perpetual bond based on their understanding of risk and investment objectives. This helps them make an informed decision about any investment.