Imagine loaning money to a company or government and collecting interest every few months forever. That's a perpetual bond -- a bond where the principal is never returned and interest is paid for as long as the borrower exists.
What's the point?Perpetual bonds are a curious product in the world of finance. After all, a perpetual bond should theoretically outlive any individual investor who buys one. But they don't exist to be sold to grandmas and grandpas looking for a little extra income.
Perpetual bonds are primarily sold to big institutions like pension funds and life insurers, which need to match their assets with their liabilities. Like a corporate borrower, the institutional investor is also assumed to have an infinite life, matching the infinite life of the bond.
For borrowers, perpetual bonds solve a number of common problems that are inherent in debt financing. First, because the bond never matures during the normal course of business, the debt won't ever need to be refinanced. (One common theme of business failure during the 2008 financial crisis is that borrowers couldn't refinance their debts that came due during the credit crunch -- perpetual bonds don't have that risk.) Secondly, perpetual bonds allow borrowers to project their interest expenses further into the future, making cash flow needs more predictable.
Naturally, perpetual bonds will have higher interest rates than shorter-term bonds. This helps cover the additional risk of lending money in perpetuity, while compensating the investor for giving up his principal forever.
Some examples of perpetual bondsBelieve it or not, in 2014, the U.K. government called perpetual bonds it issued during World War 1 (1917) as well as perpetual bonds it issued during the South Sea Bubble (1720), according to Financial Times. Investors who owned the latter bond had received interest payments for nearly 300 years!
While low rates made it economically feasible to repay perpetual bonds, other companies and governments took advantage of low rates by issuing new bonds. Noble Group issued perpetual bonds at a rate of 6% versus the 3% yield on its four-year bond in 2014. The bond had some investor-friendly provisions that kept its initial yield low -- the coupon (interest payment) was designed to reset every five years based on the ups and downs of the U.S. Treasury rate, according to the The Wall Street Journal.
Not all bonds need these step-up features to be attractive, as one company issued perpetual bonds the same year at a fixed rate of just 5.875%.
Perpetual bonds are a niche corner of the bond world, and will probably always be that way. After all, few companies are deemed so safe that they can attract investors to buy a bond in which the principal won't be repaid on a timely basis, if at all. Likewise, few investors have the capacity to lend money with the presumption that the principal will never be returned. But it is a curious part of the market, and one that makes for an interesting thought exercise in what, exactly, would compel you to lend money to a government or company forever.
The article What Is a Perpetual Bond? originally appeared on Fool.com.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.