What Are Perpetual Bonds? Calculation & Advantages

Perpetual bonds grant continuous interest payments throughout their lifetime since they do not have a maturity date. Unlike traditional bonds, a perpetual bond meaning is that it operates indefinitely with continuous returns for investors. However, it is important to note that perpetual bonds are not redeemable.

The main benefit of perpetual bonds makes them suitable for investors who require regular interest payments over extended periods.

What is Perpetual Bond?

If you’re wondering what are perpetual bonds and how do they work, you need to understand these are fixed-income securities with no maturity date. The indefinite interest payments from these bonds generate reliable returns to investors. Public entities and banking institutions use perpetual bonds to gain access to funding that spans multiple years. The periodic interest payments of perpetual bond investors do not come with the right to redeem their bond principal.

How to Calculate the Price of a Perpetual Bond

The interest payments from perpetual bonds extend indefinitely. You need to determine the present value of perpetual bond interest payments to establish its price. The crucial step in determining perpetual bonds’ yield involves using the perpetual bonds formula.

Curious about how to calculate the yield on a perpetual bond? Here is the breakdown –

Present Value of the Bond (aka Its Price)

The perpetual bonds formula determines the price value of perpetual bonds.

Price = Annual Coupon Payment/Discount Rate

For better understanding, let us consider an example.

Suppose, you receive an interest payment of Rs 25,000 per year from the bond. Applying the discount rate, say 5% you can arrive at the present value of the perpetual bond.

Thus, Price = Rs (25,000/5%)  = Rs 50000

The movement of perpetual bond prices directly correlates to required return fluctuations because increasing interest rates lead to lower bond prices.

How to Calculate the Yield of a Perpetual Bond

The yield of a perpetual bond is a key measure of its return relative to its price. It helps investors assess the income they can expect from the bond over time.

To calculate the yield of a perpetual bond, use the formula:

Yield = (Annual Coupon Payment/Price of the Bond) x 100

For example, if a perpetual bond pays an annual coupon of Rs 50 and its price is Rs 1,000, the yield would be Rs (50 ÷1,000) x 100 = 5%.

This yield represents the bond’s annual income as a percentage of its current price.

Knowing the yield helps investors compare different bonds and decide if the bond offers a suitable return based on their investment goals and the bond’s price.

How Does a Perpetual Bond Work?

Borrowers maintain perpetual bonds by paying coupon interest but never require repayment of principal throughout the bond duration, which extends indefinitely. Bondholders get ongoing interest payments starting from the day they acquire the bond until they sell it. The bond’s face value determines the fixed interest payment which the issuer pays to the bondholder. Long-term investment status applies to perpetual bonds because they offer ongoing income streams, yet their market value changes based on prevailing interest rates.

Features of Perpetual Bonds

Here are some key features that make perpetual bonds stand out.

Infinite Coupon Payments

The key characteristic of perpetual bonds is their ability to pay interest payments without any expiration date. The bondholder obtains continuous interest payments called coupons throughout their bond ownership without any specified expiration date. The periodic interest payments made to bondholders remain constant and occur twice per year or once per year. The bond’s indefinite nature of payments allows investors to receive continuous interest, which makes this financial instrument highly appealing to those looking for regular income.

Embedded Call Option

The majority of perpetual bonds include a built-in call option feature. The issuer maintains the authority to buy back the bond before its scheduled maturity term ends. The issuer possesses the right to call back the bond when interest rates drop so they can refinance at a lower cost. An embedded call option presents unfavourable effects to bondholders because early bond redemption terminates their long-term interest income.

No Yield to Maturity (YTM)

The perpetual bond lacks a yield to maturity because investors cannot determine the total return from holding it until maturity. The absence of maturity for perpetual bonds makes YTM calculation impossible because the bonds never expire. The bondholder receives a specific interest payment (coupon) throughout an undefined period, while the bond price depends on current market interest rates.

No Return of the Principal

Perpetual bonds lack the characteristic of returning the original investment amount to the bondholder. Perpetual bonds differ from standard bonds because they provide only interest payments without returning any initial funds to bondholders. The bondholder receives ongoing payments as long-term income from perpetual bonds while maintaining endless ownership of the principal amount.

Advantages & Disadvantages of Perpetual Bonds

Advantages of Perpetual Bonds

• Reliable Income

Perpetual bonds deliver dependable income streams to bondholders as their main advantage. The lack of an expiration date enables perpetual bonds to provide continuous interest payments to their bondholders. These bonds present an excellent investment choice for retirees who need consistent income because they do not expire.

• No Market-Linked Risk

The regular interest payments on perpetual bonds remain fixed because these financial instruments are not affected by market conditions. Bondholders experience no market volatility risks because of their perpetual bonds. While other investments might fluctuate based on stock market performance or economic factors, perpetual bonds provide income stability, making them ideal for risk-averse investors.

• Higher Yields

The yield rates on perpetual bonds surpass those of alternative bond types. Investors accept higher returns because their funds stay inaccessible indefinitely due to the absence of a maturity date. During low interest rate periods, perpetual bonds attract investors due to their higher returns, which surpass those of short-term and safe fixed-income securities.

Disadvantages of Perpetual Bonds

• No Repayment of Principal

Perpetual bonds function differently from regular bonds because they distribute interest payments yet avoid returning investors’ principal amount at maturity. The lack of principal return during the investment period poses concerns to investors who need to recover their initial capital because they receive only periodic coupons without the return on their initial investment.

• Interest Rate Sensitivity

Perpetual bonds react to modifications in interest rates. An increase in interest rates leads to a market value reduction for perpetual bonds since investors can obtain better returns from newer bonds. When investors need to sell their bonds before redemption or call, they face potential losses because rising interest rates decrease bond market value.

• Call Option Risk

Most perpetual bonds include a call option that enables issuers to pay back the bond ahead of schedule. The issuer possesses the right to call their bond and obtain new financing at reduced rates when interest rates decrease. A bondholder faces reduced long-term return potential because they may lose a profitable bond early, which forces them to invest at lower interest rates.

Perpetual Bonds vs Other Fixed-Income Securities

Conclusion

Perpetual bonds represent an investment instrument that grants investors ongoing interest payments without an expiration date. Dependable income streams together make them appealing to investors seeking stability while maximising their returns. However, investors need to be aware that perpetual bonds do not return the initial investment amount while they remain sensitive to interest rate fluctuations. The knowledge about perpetual bond operations and their benefits allows investors to select financial instruments that align with their objectives.