Perpetual Bonds: Equity in Disguise
In financial and economic circles, the word “forever” is rarely uttered. In fact, the word “forever” has really lost its meaning in modern vernacular, commonplace only among teenager “BFF” text signoffs.
But not anymore – “forever” is back in vogue, along with the subject of perpetual bonds.
Forever is a Long Time
A perpetual bond – sometimes referred to as a “perpetual” or “perp” – is a bond that has no maturity date.
The agreed-upon period over which interest will be paid is forever. Perpetual bonds live up to their name, paying interest in perpetuity (without a specified ending date).
Unlike issuers of standard debt instruments that expire at maturity, issuers of perpetual bonds pay coupons forever – they don’t have to redeem any principal, and cash flows occur for perpetuity.
Because of this unique characteristic, perpetuals are commonly treated as equity rather than as debt, even though they’re really debt instruments.
Why? Because perpetuals function much like a dividend-paying stock – paying a return for an indefinite time period or for example – as long as the stock is held. Think of them like a fixed interest or coupon amount divided by a constant depreciation, i.e. the speed at which money loses value over time due to inflation, even if minimal.
The History of Perps
Perpetual bonds have a long history.
The British government is often credited with creating the first in 1751. They were known as consols (short for consolidated annuities or stock) and were redeemable at the option of the government.
Perpetuals were issued by the British Treasury to pay off smaller issues used in financing the Napoleonic Wars in 1814.
Yet there is an older example of a perpetual from 1648 issued by the Dutch water board of Lekdijk Bovendams, responsible for the upkeep of local dykes.
Today this bond is in the possession of Yale University’s Beinecke Library, purchased in 2003 as a cultural artifact. This 368-year-old bond is still paying interest annually. While it was originally intended to pay 5% interest in perpetuity, the rate was reduced to 3.5% and then 2.5% in the 17th century.
And a 2.5% yield is still pretty decent, considering that, this week, for the first time in history, the Dutch 10-year government bond yields dropped below zero – making them the latest to join the negative yield club along with Japan, and much of Europe.
Not Exactly Equity
There are, nevertheless, some major differences between holding equity versus perpetuals.
For one, perpetuals don’t have attached votes. Thus, the holder does not have any rights or control over the issuer.
Secondly, because perpetuals are classified as fixed-income securities, coupon payments are mandatory.
Paying dividends on equity, on the other hand, is discretionary, and occurs only if the underlying company’s management chooses to do so.
The Market for Perpetuals
Perpetuals today are typically issued by banks as deeply subordinated bonds. Even though they are technically debt, they qualify as “equity” on the bank’s balance sheet.
Banks tend to issue perpetuals in order to fulfill their capital requirements, as they are considered Tier 1 capital (common stock and disclosed reserves). They are particularly useful when banks go under stress tests.
Buyers of perpetuals are predominantly big institutions such as pension funds and life insurers, which need to match their assets with their liabilities, with both the bond and the buyer presumably having infinite lives.
The majority of perpetuals are callable with the call protection period around five years out from the date of issuance, meaning perpetuity can be eliminated after that point should the issuer have the cash to repay the loan.
In fact, the U.K. government finally called in perpetual bonds issued during the South Sea Bubble (1720) – after paying interest for almost 300 years.
Calculation of a perpetual is straightforward, using the following formula:
Yield on a perpetual bond = I/P
Where I = the annual interest payment received by the bond holder,
and, P = the market price of the bond
The discount rate reduces the real value of the nominally fixed coupon payments over time, eventually making the value equal zero. So, while perpetuals pay interest forever, they can still be assigned a finite value, which represents the perpetual’s price.
As an example, a bond with a $100 par value, trading at a premium of $101.32 on the secondary market and paying a coupon rate of 4.75% would have a current yield of 4.69%.
Perpetuals don’t necessarily bode well for fiscal conservatives who generally abhor the idea of issuing any debt – making the idea of debt that never ends out of question. Furthermore, it signals a strategy of desperation.
And while perps are a conservative investment, they still pose risk – the most notable being the long period to carry credit risk.
After all, interest is paid for as long as the borrower exists, but who knows what the future holds. The issuer may get into trouble or at worst not be around.
And then of course, there is the risk of interest rates rising. Today, this is not a matter of if, but when.
Perpetual bonds continue to be issued today, and they hold a certain appeal, as the topic of their use as an effective macroeconomic tool has resurged among economist and central banks.
Because perpetuals eliminate the need for refinancing or restructuring, an argument can be made that issuing perpetuals would be an attractive proposition to help indebted governments as well as troubled companies to get out from their repressed states.
For this reason, perpetuals are offered in places such as India, China, and the Philippines.
When Total, the French oil company, saw crude oil quickly fall from over $100 per barrel to under $50 in February 2015, it issued a perpetual bond worth $5.7 billion.
In fact, Ben S. Bernanke, who met Japanese leaders in Tokyo last week, floated the idea of perpetual bonds during earlier discussions in Washington with one of Prime Minister Shinzo Abe’s key advisers.
The former Federal Reserve chief warned there was a risk Japan, at any time, could return to deflation and an over-reflation would be necessary.
This suggestion, however, revealed that issuing perpetual bonds is just another form of helicopter money.
In the U.S. some believe perpetuals would help the government avoid – or at least reduce – the refinancing costs associated with bond issues that have maturity dates.
And what better time to issue them than now, when interest rates are rock bottom – particularly so for long term debt. Meanwhile, investors are losing money on the government debt they already own from an inflation-adjusted interest rate of return.
Undoubtedly, at some stage, inflation will start to increase. Thus, lending money today at 3% or 4% seems like a pretty good deal for many governments, particularly when inflation surpasses those rates.
For the investor, perpetuals offer a conservative and steady source of income, allowing borrowers to project their interest expenses further into the future and making cash flow needs more predictable. Perpetuals also offer a higher rate of return than shorter term debt instruments as compensation for having to give up the principal forever.
Some perpetuals have a “step up” feature, referred to as a “growing perpetuity” meaning that the interest rate increases as at a predetermined point in the future, such as in 5- 10 years. Others may have a periodic interest rate increase.
Either way, these extras are attractive in today’s low yield environment as locking in today’s rate forever is painful.
Step ups and call features change the valuation calculation above. However, there are many free bond calculators online requiring that you just plug in the various features.
During troubled times perpetuals permit a fiscally-challenged government or troubled company to raise money and never have to pay it back.
And for the investor, they offer a conservative and predictable investment – a lot more reliable than the risk of actual helicopter money.