Perpetual bonds, as their name suggests, are unique bonds that pay interest indefinitely. Unlike typical bonds that have a maturity date, perpetual bonds continue to pay interest as long as the issuer remains solvent. This feature makes them attractive to a specific set of investors. However, the perpetual nature of these bonds also comes with its own set of risks and considerations. In this blog, we will delve into the intricacies of perpetual bonds, their issuers, the associated risks, and whether they are a good investment.
What Are Perpetual Bonds?
Perpetual bonds are debt instruments that do not have a maturity date. Investors receive interest payments forever or until the issuer decides to call back the bond. This call option allows the issuer to redeem the bonds at specific times, usually after a fixed term like five or ten years or when certain conditions are met.
Issuers of Perpetual Bonds in India
In India, both government entities and corporations can issue perpetual bonds. However, banks are the predominant issuers of these bonds, primarily to strengthen their financial position and meet capital adequacy requirements. These bank-issued perpetual bonds are commonly referred to as Additional Tier 1 (AT1) bonds.
Banks like SBI, HDFC Bank, and ICICI Bank frequently issue AT1 bonds. These bonds are used to bolster the banks’ Tier 1 capital, a critical component of the capital base required to ensure stability and solvency. The high-interest payments associated with perpetual bonds make them an attractive option for banks to lure investors.
Risks Associated with Perpetual Bonds
While perpetual bonds offer enticing interest rates, they are fraught with risks, making them unsuitable for many retail investors. Here are some of the key risks –
- Lowest Seniority – In the event of liquidation, perpetual bondholders are at the bottom of the repayment hierarchy, just above equity shareholders. This means they are paid after all other debt obligations have been settled. This lower seniority was highlighted during the YES Bank crisis in 2021 when AT1 bondholders faced significant losses as the bonds were written off to protect depositors.
- Principal Repayment – Unlike traditional bonds, perpetual bonds do not repay the principal unless the issuer exercises the call option. Investors need to be comfortable with the possibility of never getting their principal back.
- Market Liquidity and Price Volatility – If an investor needs to sell a perpetual bond, they may face difficulties due to low liquidity. Additionally, bond prices can fluctuate significantly with changes in market interest rates, potentially leading to substantial capital losses if sold before a favourable call option is exercised.
- Issuer’s Right to Write Off – Regulatory provisions allow banks to write off perpetual bonds under financial duress to safeguard depositors’ interests. This regulatory risk adds an additional layer of uncertainty for investors.
Interest Rates of Perpetual Bonds
Due to the higher risk profile, perpetual bonds typically offer high interest rates to attract investors. It is not uncommon to find perpetual bonds with interest rates of 8% or higher. This high yield compensates for the elevated risk and the perpetual nature of the bond, making it somewhat akin to equity in terms of risk and return dynamics.
Who Should Invest in Perpetual Bonds?
Perpetual bonds are best suited for institutional investors or high-net-worth individuals with a high-risk appetite and a need for steady interest income without the need for principal repayment. These investors are typically more capable of assessing and managing the associated risks.
Advantages of Perpetual Bonds
The primary advantage of investing in perpetual bonds is the potential for lifetime interest payments. This can be particularly appealing for investors seeking a steady income stream over an indefinite period. The high interest rates offered by these bonds can also be a significant draw.
Conclusion
Perpetual bonds in India offer a unique investment opportunity with the promise of indefinite interest payments. Issued primarily by banks to meet regulatory capital requirements, these bonds come with high interest rates to compensate for their high-risk nature. However, the risks—ranging from low seniority in the capital structure, potential write-offs, market liquidity issues, and the non-repayment of principal—make them unsuitable for most retail investors. Instead, these bonds are more appropriate for institutional investors or individuals with substantial risk tolerance and a specific need for perpetual income.
Investors considering perpetual bonds should conduct thorough due diligence and consider their risk tolerance and investment horizon. While the high yields can be attractive, the potential for capital loss and the complexities associated with these instruments require careful consideration.
