Perpetual Bonds vs. Other Fixed- Income Securities
Fixed-income securities generate known and predictable interest payments. They are considered one of the building blocks of any diversified investment portfolio. There are many forms of fixed-income securities, each of which has very different characteristics, suited to various types of investors and goals. Perpetual bonds are an almost unknown form of fixed-income security and attract attention because of their structure and associated risks . What are perpetual bonds ? How are they different from other fixed-income securities, such as traditional bonds, fixed deposits ( FDs ) , and bond ETFs? At what point should they be considered?
What are Perpetual Bonds?
Perpetual bonds are undated or ” forever bonds, ” which means they have no maturity date and no actual repayment of principal . Instead, they represent an investment in which periodic interest payments, usually at a fixed rate, are made indefinitely or until called by the issuer, if the bond has a callable feature. In this regard, perpetuities resemble equity investments since they can imply a perpetual income without an end date. They are issued by banks and corporations when they want to raise capital without being concerned about the repayment of debts.
Fundamental Characteristics of Perpetual Bonds
No Maturity Date: A perpetual bond does not have a maturity date like other bonds . This implies that investors will earn interest indefinitely
The issuers also use a higher yield on perpetual bonds than on any other bond issued. This is because investors might be apprehensive about an open-ended commitment.
Callable Feature: Many perpetual bonds have a “callable” feature , whereby the issuer may redeem the bond after a certain period, usually between 5 to 10 years , provided that market conditions are favorable.
Credit Risk: Perpetual bonds have higher credit risk, especially when issued by corporations. In other words, if the financial position of the issuer becomes worse, chances are that the interest payments can be deferred or cut off.
Comparing Perpetual Bonds with Other Fixed-Income Instruments
To understand where perpetual bonds fit in the spectrum of fixed-income investments, it is helpful to compare them with other popular securities: traditional bonds, fixed deposits (FDs), and bond ETFs.
Traditional Bonds: Fixed Terms with Principal Repayment
What are they?
Traditional bonds are a type of fixed-income security issued by either governments or corporations that promise to return the principal at the close of a term and ensure the payment of regular interest during the life of the bond. The terms typically range from several months to 30 years, providing investors with a defined end and income stream.
Perpetual Bonds vs. Traditional Bonds
Maturity: Traditional bonds have maturity, whereas perpetual bonds do not. This makes traditional bonds more favorable for investors that want a specific timeline of capital return.
Yield: Perpetual bonds generally have a higher yield as they are perpetual or never-ending in nature.
Risk: Perpetual bonds are, in general, more risky as compared to traditional ones. Without any maturity date, an investor faces credit and interest rate risks for a much longer period.
Best for: Traditional bonds are suitable for investors that want predictable returns and principal repayment at a specific date. Perpetual bonds are best for the investment followers who want long-term income but risk tolerance could be higher.
What Are Fixed Deposits (FD)?
Fixed deposits (FDs) are savings products offered by banks , whereby investors deposit a lump sum for a fixed term in exchange for guaranteed interest payments. FDs have a fixed period and are usually insured by the government (up to specific limits), thus providing safe and reliable returns.
Perpetual Bonds vs. Fixed Deposits
Maturity and Liquidity: FDs have a known term-a period of 1, 3, or 5 years-because redemption is made at maturity, whereas the perpetual bond goes on indefinitely and the issuer can call the same at any time.
Risk and Returns: FDs are one of the safest investments with guaranteed returns. Perpetual bonds come with a certain higher yield but are riskier and might be prone to suspensions or reductions in interest payment.
Tax Treatment: Interest from FDs is taxed with income tax, which means that returns would be lower. For Perpetual bonds, interest would be taxed too, but some kinds of bonds have tax benefits in some territories.
Recommended for: FDs are best suited for risk-averse investors seeking assured returns and capital protection. In view of the high risks, Perpetual bonds would best suite savvy investors who do not mind the fluctuation possibilities of income.
Risk: Generally, perpetual bonds are considered riskier than the traditional bonds. Because of no maturity date, there is a prolonged exposure to credit risk and interest rate risks.
Best for: Traditional bonds are best for investors who require predictable returns and principal repayment at a specified date. Perpetual bonds, on the other hand, are best for those who require long-term income but can stomach higher risk.
What are Exchange-Traded Funds?
Bond Exchange-Traded Funds (ETFs) are funds that hold a diversified portfolio of bonds and are traded on stock exchanges like stocks. Bond ETFs provide exposure to various bonds (government, corporate, etc.) and allow the purchase or sale of shares throughout the day.
Liquidity: Bond ETFs are bought and sold each day on the stock exchange, so high liquidity. Perpetual bonds, though sometimes tradable, are otherwise illiquid and held long-term for yields.
Diversification: Bond ETFs automatically bring diversification across several bonds. That reduces the risk. Perpetual bonds, being single securities, do not offer this benefit.
Yields/Risks: Obviously, it is true that perpetual bonds pay far higher yields than diversified bond ETFs, mostly because they never mature. Risk and predictability of returns are much better with bond ETFs, because the benefits of holding a diversified group of bonds are higher.
Suitable for: The best use of bond ETFs is with investors who require both fixed income and daily liquidity in an investment with lower risk. Perpetual bonds serve the objectives of investors seeking high income without a need for current liquidity.
Long-term benefits and disadvantages of perpetual bonds
Pros
Higher Yield: Generally, perpetual bonds tend to carry higher yields compared to other fixed-income securities. On this account, it is highly appealing to those investors who have an appetite for income.
Continuous Income: Accrued interest could be continuously paid, and thus a stable income can be attained.
Cons
Lack of Principal Repayment: The main disadvantage is no principal repayment, and investors solely work on interest payments to generate returns.
Interest Rate Sensitivity: Because perpetual bonds do not possess a maturity date, they are quite sensitive to interest rates. An increase in rate will reduce its market value.
Credit and Liquidity Risks: The perpetual bonds issued by companies do come with credit risk, and due to a lack of liquidity, it might be difficult to sell these bonds in the secondary market.
Summary
Perpetual bonds are best suited for mature income -focused investors who can stomach the vagaries of interest rates and market conditions . Investors who emphasize regular income and are prepared to accept the risks inherent in perpetual duration may opt for perpetual bonds, particularly if they seek a yield higher than what is available in government bonds or fixed deposits.
However, for conservative investors, traditional bonds, fixed deposits, or bond ETFs might actually be better choices , as the end date of the instrument is clear and they are generally less risky. In a fully diversified portfolio , perpetual bonds may serve as a good option, as they add a degree of balance between risk and return.
Perpetual bonds offer higher yields but carry much greater risks due to their indefinite timeframe. They represent a more fundamental difference from bonds in general, fixed deposits , and bond ETFs in terms of structure, risk, and return. Much like any other investment, one must first evaluate the circumstances related to their own financial goals, risk tolerance, and investment horizon before adding perpetual bonds to their overall portfolio. With proper usage , they can complement other fixed-income securities and provide an attractive income stream .