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Can you explain the term “perpetual bond”?

Understanding Perpetual Bond

A perpetual bond, also known as a consol or perpetuity, is a fixed income security with no maturity date. This means the holder of such bonds receives interest payments indefinitely.

Structure of a Perpetual Bond

Perpetual bonds are structured as coupon or interest-only investments. The issuer of these bonds commits to making regular interest payments, typically annually or semi-annually, for an infinite period. However, unlike traditional bonds, the issuer does not return the principal amount even on the assumed maturity date. The investors keep receiving interest payments as long as they hold the bond, even if the company dissolves, assuming that the issuer remains solvent and in business.

Characteristics of Perpetual Bonds

Perpetual bonds possess unique characteristics that distinguish them from regular bonds.

1. No Maturity Date

As mentioned earlier, perpetual bonds do not have a maturity date. The investor will keep receiving interest payments forever or until they decide to sell the bond.

2. Fixed Interest Payments

The issuer of a perpetual bond commits to a fixed interest rate at the bond’s inception. The interest payment is based on this rate and does not change over the entire duration of the bond.

3. No Principal Repayment

The principal amount, or the face value, is never repaid to the bondholder. The bondholder only receives the promised fixed interest payments.

4. Sensitivity to Interest Rate Changes

Perpetual bonds are extremely sensitive to changes in interest rates in the market. A rise in market rates will decrease the price of the bond and vice versa.

Valuation of Perpetual Bonds

The valuation of a perpetual bond is relatively simple compared to other types of bonds due to their unique characteristics. The principal sum of a perpetual bond is theoretically considered to be the sum of an infinite series of cash flows. Given that the payments consist of a fixed interest rate, the present value of all future cash flows becomes:

Price of the Bond = C / r

where:

C = Annual coupon payment
r = Yield or discount rate

To explain, if the coupon payment is $50 and the yield is 5%, the price of the bond will be $50 / 0.05, which equals $1000.

Perpetual Bonds and Investment Considerations

Perpetual bonds, due to their unique characteristics, have certain advantages and disadvantages that investors might consider.

Advantages

The primary advantage is the infinite stream of interest payments. These can be attractive to investors seeking long-term, regular income. Additionally, perpetual bonds typically offer higher interest rates compared to other bonds.

Disadvantages

The major disadvantage is the lack of principal repayment. The issuer never returns the original investment, which can be a deal-breaker for many investors. Furthermore, perpetual bonds are more sensitive to interest rate changes—should interest rates rise, perpetual bonds decrease in value more than bonds with maturity dates.

Final Reflections

While perpetual bonds can be a good source of regular and potentially high income, they also require careful consideration due to their lack of principal repayment and their sensitivity to interest rate fluctuations. Investors must carefully consider these factors before investing in perpetual bonds.