Perpetual Bond

A perpetual bond is a debt security that has no fixed date on which the principal must be repaid. The issuer pays interest for as long as the bond remains outstanding, which in principle is for ever. Most perpetual bonds give the issuer an option to redeem them at set dates, so in practice many are repaid, but the holder has no right to demand repayment. Perpetuals are also called perps or, in older usage, consols.

Because the principal is never due, a perpetual bond has features of both debt and equity. It pays a contractual coupon like other bonds, but it provides permanent capital like shares, and it generally ranks below the issuer's other debt. For that reason perpetuals are used chiefly where an issuer wants financing that regulators, rating agencies or accountants will treat at least partly as equity: bank capital instruments and corporate hybrids are the main examples.

The best-known perpetuals were the British government's consolidated annuities, or consols, first issued in the eighteenth century to consolidate earlier borrowings. They traded for more than two hundred years, and the government redeemed the last of them in 2015. Other governments issued similar undated stock, including to finance wars, and a few corporate and municipal perpetuals from earlier centuries still pay interest. Sovereign issuance is now rare; the modern market is dominated by banks, insurers and large companies.

With no principal repayment to discount, the value of a perpetual that is never redeemed is the present value of an endless stream of equal coupons:

• $P$ is the price of the bond.
• $C$ is the annual coupon payment.
• $r$ is the yield investors require, written as a decimal.

A perpetual paying 5 a year, when investors require 4 per cent, is worth 5 divided by 0.04, or 125. If the required yield rises to 5 per cent, the price falls to 100, a drop of one fifth. This illustrates the main market characteristic of perpetuals: their prices are very sensitive to changes in interest rates, more so than any dated bond of similar coupon. In practice, investors in callable perpetuals usually value them to the first call date and quote a yield to call, on the assumption that the issuer will redeem.

Almost all modern perpetuals are callable. The issuer may typically redeem at par on a first call date five or ten years after issue and periodically thereafter, in the same way as a callable bond. If it does not, the coupon is usually reset to a new rate, set as a fixed margin over a reference rate prevailing at that time.

Older instruments often included a step-up, an increase in the margin after the first call date that gave the issuer a strong reason to redeem. Regulators now prohibit such incentives in bank capital instruments, because they make a perpetual behave like dated debt. The risk that an issuer chooses not to call, leaving investors holding the bond for longer than expected at a coupon below market, is known as extension risk. Decisions not to call have at times caused sharp price falls across the market.

The largest category of perpetuals today is Additional Tier 1 capital issued by banks under Basel III. To qualify, an instrument must be perpetual, with no incentive to redeem; the bank must have full discretion to cancel coupons without this counting as a default; and the principal must be written down or converted into shares if the bank's Common Equity Tier 1 ratio falls below a trigger, or if the authorities judge the bank to be no longer viable. Redemption requires the supervisor's permission. These features place the instruments between shares and Tier 2 capital in the order of loss absorption.

The risk became concrete in March 2023, when the takeover of Credit Suisse arranged by the Swiss authorities involved the complete write-down of about 16 billion Swiss francs of its Additional Tier 1 bonds while shareholders received some value. The outcome, which followed the terms of those particular bonds, surprised many investors and led other regulators to restate that equity would normally bear losses first.

Non-financial companies issue perpetual or very long-dated subordinated bonds, known as corporate hybrids, to support their credit ratings without issuing shares. Coupons can be deferred at the issuer's option, usually on a cumulative basis. Rating agencies commonly treat half of the amount as equity when assessing leverage, and under international accounting standards an instrument with no obligation to repay principal or pay coupons can be classified as equity on the balance sheet, a question governed by IAS 32. Interest is nonetheless often deductible for tax, which is part of the appeal.

Holders of perpetuals face interest rate risk from the long duration, extension risk from the call option, and credit risk heightened by subordination, since in insolvency they are paid only after senior and ordinary subordinated debt. Coupons may be skipped. The instruments are complex, and several jurisdictions restrict their sale to retail investors. In return they offer a higher credit spread than the same issuer's senior debt. They are distinct from preferred stock, which is legally equity, and from the convertible bond, which converts at the holder's option.