What Are Perpetual Bonds? Bond Baba Explains

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You can’t live forever, they say. But some things can. And one of those things is probably a “Perpetual bond“.

Bond Baba knows your next question. What the heck is a perpetual bond? The idea is this: You give someone money when you buy a bond. They pay you some interest. Then at some later point in time, they pay you back the principal. That’s about it.

Imagine a bond which doesn’t have the second part. They never pay you back the principal. Just the interest. Forever.

How can you get your principal back? Well, maybe someone else wants to buy the bond from you because the interest rate is high. And that will give you back your capital, but you won’t earn any more interest.

And that, my friends, is a perpetual bond. It’s issued by the company, but will only pay you interest, not principal.

Attempting to Lock in Long Term Rates

All our retirement calculators assume you can get 8% in a low risk environment in the longer term. But imagine the US person who was 40 in 1996 and thought he could get 6% when he retired. There’s nothing at 6% now in the US, that’s low risk!

To avoid this you might say, let’s buy the perpetuals, to lock in a yield for the ultra long term – even till you’re 90! (But there’s issues with this thought process, as we will see later)

Why Bother? Why Can’t I Just Buy A Regular Bond Instead?

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One word: Greed. Perpetuals give you way more interest than a regular bond. And technically, the interest keeps coming every year.

Look at this Bank of India bond. It’s a perpetual that was issued at a yield of 11.50% in June 2016. The minimum purchase is Rs. 10 lakh per bond, but this bond is for cash flow for a specific purpose:

This bond can be considered if you need cash flow and are in a low-tax bracket – typically, a retiree with no other income. 

The bond pays 11.5% – so for Rs. 10 lakh you will get Rs. 115,000 per year. At current tax rates, a person that is 60+ can buy three bonds, for about 345,000 a year. The first 300,000 is free anyhow (for 60+) and then you can offset the 45K with some purchases of a term instrument like ELSS funds or such. (Or just pay the Rs. 4500 tax – it’s nothing for having earned 3.45 lakh)

But Isn’t There A Catch?

Of course. There are always catches. Which don’t always win matches.

First, how do you sell this bond? If you need money, there’s no redemption date at all. (It’s a perpetual bond, remember) You have to find someone to buy it. Here’s where the biggest problem is.

You have, let us say, three bonds. That’s 30 lakh worth of bonds. If you want to sell it, someone needs to want your three bonds. In the wholesale market, though, the minimum that is traded is 50 bonds (and multiples of 50 bonds). So if you try to sell you may not get the market price or even close – you may get a lot lesser. These bonds aren’t listed on the NSE/BSE yet, so you have to depend on your bank or broker to find a buyer, which adds on additional fees.

There is another issue – the call option. The bonds are “callable” by the bank. The bank, anytime after 10 years, can say please give back the bonds I’ll pay you the face value. But it’s an option – so the bank can choose not to. This is not good for you.

Why will the bank call back its bonds? If the interest rate then prevailing is much lower. If it is lower, then that means your “locking in” 11.5% is all gone! You can buy other bonds, but then they will quote at a lower rate than 11.5% (which is why the bank chose to exercise the call option). The only small positive is that you get your money back, but that’s hardly a positive – if you were afraid that you wouldn’t get paid, you would never have invested in the first place.

The bigger issue is: the PONV. The Point of Non-Viability is a feature in these bonds that allows the bank (after consultation with the RBI) to “default” on part of the coupon, or the principal if it is decided that the bank cannot viably continue without this write-off. That means this: you lose money. You will lose principal, and you will lose interest. If Bank of India falls down the pit of extreme losses, they could say, ok, forget about Rs. 4 lakh out of the Rs. 10 lakh principal. That means they can pay the 11.5% but only on the remaining 6 lakh principal. Which means you have lower interest, and a lower resale value due to the write off. You have no control over this.

Lastly, there is the default risk. Bank of India is run by the government so it may not default (but the PONV might still happen). But there is default risk in companies like Tata Motors, or Chola Finance (which also seem to be offering perpetual bonds).

So Should Every Retiree Buy Perpetuals?

Well, no. In a case like SBI or Bank of India, this may have some default risk (through a PONV). The extra coupon pays for that risk. But it’s also illiquid – so if you need any portion of your investment back, you’re stuck.

A retiree can take a small exposure – perhaps at the 10-20% of portfolio level in total – to multiple perpetuals so the risk is spread out. But it shouldn’t be done by someone who would be scared of the illiquidity or the default risk.

You might think: Why not buy this bond and keep it for retirement anyway? After This bond may not make a lot of sense for someone who’s working now. The default risk etc. apart, the point is that the bond’s likely to be called in 10 years, so if you aren’t retiring in 10 years, you might not really be locking in money for the longer term. So for such people this may not be useful.

However, it’s a good option as a low-liquidity 10 year high yield investment to someone who understands and accepts the risk.

The Other Stuff

You can’t buy such bonds easily.  They’re not on stock exchanges. These are bought through a private placement. If you would like to know when such issues come about, let us know by replying to this mail. If there’s enough demand, we’ll get this into a mailing list accordingly.

We expect more such bonds to be issued soon. Why? Because all banks need to bump their capital ratios up for Basel III in 2019. Bank of India was one earlier this year, but a lot of Public Sector Banks also will do it. These help with Tier II capital – since technically the bonds never have to be returned. (and they will be returned only in special circumstance like when the Bank has called it – which cannot happen if the capital ratios are not good)

The investing opportunity may look fantastic if these bonds are not “called” – since 11% for a long time sounds just great. If India solves the bond market issue of illiquidity, we could see more such bonds purchased since people seem to be comfortable that public sector banks at the very least will not default. We obviously can say “Be Careful” – but that doesn’t mean you shy away from the risk – a lower allocation, but an allocation nevertheless, may be in order.