What is a perpetual bond ?
A Perpetual bond is a fixed income security that pays interest income to its holder forever i.e., in perpetuity. It does not have a fixed maturity date and is irredeemable. It is also known as “Consol bond“ or “ Prep “.
How is the present value of a perpetual bond calculated ?
The price of a bond is the sum of the present value of interest payments and the present value of the principal amount ( par value) of the bond when redeemed.
Since perpetual bonds are not redeemed, their value is simply the sum of present value of the perpetual interest payments from the bond.
Thus the present value of a perpetual bond is calculated using the formula
Present value of a perpetual bond = C / r
Where C = Annual Coupon ( Interest) ; r = Market Interest rate ;
Are perpetual bonds a good Investment avenue ?
Perpetual bonds have historically paid a higher rate of interest when compared to similar bonds in the market. They ensure a steady stream of interest payments forever to the investor.
Some perpetual bonds are issued with a “coupon step – up “, wherein the interest rate on the bonds increases as per a pre-set timeline. The investor receives a higher coupon payment with each coupon step-up.
Bonds, being a debt obligation, the likelihood of a company defaulting in interest payments is less.
Also, perpetual bonds occupy a fairly small share of the total bond market. They are usually issued by banks and Government agencies, thereby granting a higher level of surety with respect to perpetual interest payments.
What are the drawbacks of investment in perpetual bonds for an investor ?
Perpetual bonds are irredeemable and so the principal amount of the bond is lost and never returned.
The funds of the investor are forever blocked and may be released only when the issue decides to call back the bonds. The payback of the principal investment in the bonds is at the discretion of the issuer.
Since the principal investment is blocked forever, the opportunity of investing the principal amount in other highly profitable options available in the market is lost.
Calculation of present value of a perpetual bond :
ABC Co. has issued perpetual bonds of $ 1,000 par value, having a coupon rate of 5 %. The market interest rates on such bonds is 10 %. Find the present value of the perpetual bond.
As per the information provided in the question we have
Par value of the bond = $ 1,000 ; Annual coupon rate = r = 5 % = 0.05 ; Market Interest rate = 10 % = 0.10 ;
The annual coupon = Par value of the bond * Annual coupon rate = $ 1,000 * 0.05 = $ 50
The formula for calculating the present value of a perpetual bond is
Current value of perpetual bond = C / r
Where C = Annual coupon ; r = Market Interest rate ;
Applying the above values in the formula of present value of the bond we have
= $ 50 / 0.10
= $ 500
The present value of the perpetual bond is = $ 500