What are Perpetual Bonds?

Perpetual bonds last till perpetuity i.e. the bonds never mature. There is no maturity date for these bonds. Therefore, the issuer never has to return the principal. The issuer just needs to keep paying the principal. Such bonds cannot be redeemed.

Many Public sector banks have issued perpetual bonds in the recent years.  The banks have other motives behind issuing such bonds. These are deeply subordinated and qualify as Tier-1 capital, helping the banks meet capital requirements as per Basel-3 norms. The coupon for such bonds has ranged from 9.5% p.a. to 12% p.a.

In this post, I will not concentrate on trading aspects of perpetual bonds. Traders or smart investors may take call on interest rate movements or outlook on yield gap (with government bonds) to make investment decisions. There are many dynamics at play.  Hence, I would desist from broaching such discussion.  I will focus on investors who want to take exposure to such bonds because of high interest rates.

Perpetual Bonds may have a Call option

Perpetual bonds may have a call option. It effectively means the issuer can buy back the bonds (redeem forcefully) when it so desires.

An issuer will exercise the call option if the interest rates in the economy drop substantially. In such a case, the issuer will pay back the bond holders and reissue bonds at a lower interest rate. This will bring down interest cost for the company.

Typically, call option is not exercised based on whims and fancies of the issuer. It can only be exercised at regular intervals, say after 5 years, 10 years and so on. Such details are provided in the bond prospectus.

Everything else being same, it is fair to expect higher coupon for bonds with call option than bonds without call option.

Pros of Perpetual Bonds

1. You can lock-in the interest rate for a very long term. You don’t have to worry about interest rates going up or down.
2. The interest rate on offer can as high as 2.5%-4.0% over 10-year benchmark Gsec yield. The interest rate (coupon) offered will also depend on the credit-worthiness of the issuers. Lower the credit quality, higher the interest rate on offer. Therefore, by investing in such bonds, you can earn a much higher rate of interest than you would earn in a bank fixed deposit.

Cons of Perpetual Bonds

1. Your investment is technically stuck for ever. Even though you can exit in the secondary market too or in an over-the-counter deal. However, you need to watch out for liquidity in such bonds.
2. You have to trust the credit quality of the issuer for eternity. If fundamentals of the company worsen after a few years, you wouldn’t have an easy way out.
3. Since the bonds are deeply subordinated, the claims of other bond holders will hold higher priority over perpetual bond holders (in case of liquidation).
4. You must go through the covenants. There may be conditions that in the event of losses, the coupon for the year may be skipped. This makes these bonds quasi-equity. In fact, that’s the reason these bonds qualify as Tier-I capital for banks. So, even though you bought the bond for a high coupon, you may not get any interest income in bad times.

Taxation of Perpetual Bonds

Interest income from such perpetual bonds will be taxed.

If you sell in the secondary market before 1 year, any capital gains will be taxed at your marginal income tax rate.

If you sell in the secondary market before 1 year, the capital gains will be taxed at flat 10%. There will be no benefit for indexation.

How to purchase Perpetual Bonds?

I am not very clear about this aspect.  If you have better clarity, then please leave your inputs in the comments section. Many a times, these bonds are issued on private placement basis. Hence, retail investors may not always have access to these bonds.

You can also buy/sell bonds from Wholesale Debt Segment on BSE/NSE. Here is information about Bank of Baroda perpetual bonds issued in January 2015. Liquidity is likely to be very low for such bonds.

You can see only 10,000 bonds each with face value of Rs 10 lacs each were issued. How much liquidity can you expect in such issues?

Should you invest in Perpetual Bonds?

These bonds may even be out of reach of many retail investors. Minimum denomination size can be as high as Rs 10 lacs (typically the minimum denomination is Rs 1 lac). You can see in the above snapshot about Bank of Baroda perpetual bonds, the face value is Rs 10 lacs. Hence, many of us may not even need to make the choice. Good riddance.

If you do not seek regular income, there is no point going for such bonds. If you seek regular income, then these bonds may fit your portfolio. Since the interest is taxable, the greatest benefit will accrue to investors in the lower income tax brackets.  However, minimum denomination size can be a huge impediment for such investors.

You also need to see how many in the lowest income tax bracket can shell out Rs 10 lacs for investment in perpetual bonds. Access to such bonds is not easy either.

You also need to look at interest rate differential. State Bank of India issued perpetual bonds worth Rs 2,100 crores at 9% p.a. in September 2016. Post-tax yield will be much lower since the interest is taxable.  Yes Bank subscribed to the entire issue of bonds. You can get comparable or even post-tax returns with debt mutual funds (and with much lesser liquidity issues).

In my opinion, perpetual bonds (especially the ones by PSU banks) are not for retail investors. So, relax and ignore such issues.

HNIs can look at perpetual bonds for specific needs.

Additional Read/Source

1. HDFC Securities Primer on Perpetual Bonds
2. Bank of India: Information on Bonds issued (Dated August 1, 2016)