Perpetual Bond

International Financial Management Perpetual Bond

Semester Fourth 2011Instruction: Answer ALL questions. Marks will be awarded for good presentation and thoroughness in your approach. NO marks will be awarded for the entire assignment if any part of it is found to be Copied directly from printed materials or from another student. complete this cover sheet and attach it to your assignment.

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Submission Date

10-05-2011 Due Date 10-05-2011

Student's ID 51,15,28 Course Name International Financial Managment

Student's Full Name

Masood Sadiq, Waheedullah Khan, Adeel Sittar

Lecturer's Name

Mr. Syed Tauqeer Ahmad

COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 1

Student declaration:

I declare that: I understand what is meant by plagiarismThe implication of plagiarism have been explained to me by my institutionThis assignment is all my own work and I have acknowledged any use of the published or unpublished works of other people.

Student's signature: Masood Sadiq, Waheedullah khan, Adeel Sittar

Date: 10-05-2011


Table of contentIndex Explanation Page No.

1 Title Page 1

2 Bissmillah 2

3 Table of Content 3

4 Introduction to perpetuity bond 4

5 How to calculate perpetual bond 4-5

6 Risk 5-6

7 Capital Requirement 6

8 Advantages 6-8

9 Disadvantages 8

10Comparing Perpetual Bond Common Stock &

Preferred Stock

9-11

11 Conclusion 11


Perpetual Bond OR Console BondA bond with no maturity date. Perpetual bonds are not redeemable but pay a steady stream of

interest forever. Some of the only notable perpetual bonds in existence are those that were issued

by the British Treasury to pay off smaller issues used to finance the Napoleonic Wars

(1814). Some in the U.S. believe it would be more efficient for the government to issue perpetual

bonds, which may help it avoid the refinancing costs associated with bond issues that have

maturity dates. In case of liquidation creditors and depositors pay first and second pay bond

holders.

A perpetual bond is also known as a 'consol' issued by the UK Government

Examples of perpetuity:

Local governments set aside monies so that funds will be available on a regular basis for

cultural activities.

A children’s charity club set up a fund designed to provide a flow of regular payments

indefinitely to needy children.

How to calculate perpetuity?

According to book “business formulas” that perpetual bond are that have no maturity date, for

computing the yield on the perpetual bond is

I/P OR coupon rate* face value

Market yield

I = interest rate

P = market value of the bond

For Example:

Bond P has a $1,000 face value and provides an 8% annual coupon. The appropriate discount

rate is 10%. What is the present value of the perpetual bond?


I = $1,000 ( 8%) = $80.

kd = 10%.

V = I / kd [Reduced Form]

= $80 / 10% = $800.

Example: Assume a $1000 face value perpetual bond with a market price of $950 paying $120 in

annual interest what is the yield of the bond.

120/950= 0.1263=12.63%

Example: Alan wants to retire and receive $3,000 a month. He wants to pass this monthly

payment to future generations after his death. He can earn an interest of 8% compounded

annually. How much will he need to set aside to achieve his perpetuity goal?

Solution: R = $3,000

i = 0.08/12 or 0.00667

Substituting these values in the above formula, we get

$3000

A ∞ = ---------

0.00667

= $449,775

If he wanted the payments to start today, we must increase the size of the funds to handle the first

payment. This is achieved by depositing $452,775 which provides the immediate payment of

$3,000 and leaves $449,775 in the fund to provide the future $3,000 payments.

Risks

Fixed-rate securities are subject to interest rate risk because a bond's market price is

inversely related to interest rates. When prevailing market interest rates are high, bond


prices decline. Conversely, if market interest rates are low, bond prices rise. The idea is if

market interest rates are high, bond investors would rather get a higher return on newly

issued bonds featuring the prevailing higher interest rates. Some other risks include

credit, prepayment, reinvestment, volatility and yield curve risk.

Capital Requirements

Perpetual bonds are typically sold by banks, which generally retain the right to call them after

five years. They rank as Tier 1 capital and help lenders fulfill their capital requirements.

What Does Tier 1 Capital Mean?

A term used to describe the capital adequacy of a bank. Tier I capital is core capital; this includes

equity capital and disclosed reserves.

Investopedia explains Tier 1 Capital

Equity capital includes instruments that can't be redeemed at the option of the holder.

Advantages

Anyway, the main advantage for the issuer is that capital that it doesn't have to pay back is

considered equity, and can be leveraged. This is of great value, as it allows a company to have a

bigger operation without having to raise equity by issuing stock. Issuing stock would dilute the

value of stock held by current investors. The main disadvantage is that payment of the interest is

mandatory, whereas a company doesn't have to pay a dividend. However, in some bonds, the

company can defer the payment of the interest when it doesn't pay a dividend. It's like stock, only

it doesn't carry voting rights.

A second major advantage is the fact that most of these issues offer the right, but not the

obligation, for the company to redeem the bond, by paying it back. In other words, the company

has a call warrant on the bond, and the owner of the bond is short that warrant. The terms for this


call vary; often, it may only be exercised in a few years, and then for instance once a year. The

company might exercise this call if it can find cheaper money elsewhere - perhaps a regular

bond, or a perpetual bond with a lower interest rate. Of course, it doesn't have to do this; if the

current arrangement is cheaper, it will just keep it. In practice, this means the company will

redeem when interest goes down, and will keep the bond when it goes up.

So, in other words, the person buying this bond doesn't know when he will get his money back

and isn't even sure of an interest payment if it's linked to the dividend. Worse, the investor is

pretty much guaranteed that he will get his money back when interest is lower, so he won't be

making as much as he would have when holding the bond. If the interest were to skyrocket, the

investor would rather have the money and invest it somewhere else where it would yield even

more interest. So, why would anyone buy this faux stock?

The reason is interest. The interest on these products is often very high for several reasons:

The duration is long. Long-dated bonds are much more risky than short-dated bonds; this

is reflected in a higher interest rate.

The interest a company has to pay is higher that a government has to pay, because the

company can default. This effect is amplified by the long duration of the bond, especially

for a company that might be quite solvent now, but may not be in a decade or two.

The call option the issuer has is valuable, and the investor has to be compensated.

Often, these bonds are subordinated. This means that should the company default, other

bondholders get paid first. In practice, this more likely than not means that a default

means your entire investment is gone.

For products such as these, receiving 2-3% more interest than a 10-year government bond is

probably the lower limit an investor should accept. The payment should initially never be less

than the dividend, either, as the dividend should go up in the long run, while the interest won't.

Often, these products are tradable. It is worth noting that in this case, the interest is computed

over the value of the principal, not the price one pays. For instance, imagine a perpetual 8% bond

is trading at 70 Euros with a principal of 100 Euros. In this case, 1000 Euros buys roughly 14


bonds, which pay 1400 * 8% = 112 Euros of interest, or 11.2%. Should the company decide to

pay back its bonds, it will pay 1400 Euros, making the investor another 40%.

As discussed, this product is rather risky for an investor to hold. The main risks are:

Market risk. The price of the bond can fluctuate in the market. If the investor is under no

pressure to sell, this in itself doesn't really matter, as the interest stream doesn't change.

Market risk for an interest rate increase. If the interest rate goes up, it would be relatively

better to invest in other bonds. This will manifest in the price of the bond. If you are a

private investor, you will probably find this a bit annoying; for a professional player who

may have bought the bond with borrowed money, the immediate loss in the bond price

hurts. As a very rough rule of thumb, a percentage point of interest rate increase may

depress the value of the bond by about 5 to 10% (although I can think of many

exceptions).

Market risk for an interest rate decrease. This will move up the price of the bond-by just a

little. While the perpetual bond becomes a better investment relative to other bonds,

leading to a price increase, the effect is minor as it becomes very likely the issuer will

redeem the bond.

Default risk. If the market thinks the issuer will default, the value of the perpetual bond

will drop very fast. Of course, if the company actually defaults, the entire investment is

gone.

Disadvantages

bond will never yield a huge profit for a short period of time

Investor cannot decide to hold bond until maturity to receive a lump sum payment

Treated as equity not debt

Similar to low volatility stock that pays dividends

As one can see, there are many reasons for the price of the bond to go down, while there is very

limited potential for it to go up. This is compensated for by the high fixed return. In fact, for


modest price drops, say caused a 1% increase in interest rate, this return is so high that the

investor is still breaking even.

Comparing Perpetual Bond Common Stock &

Preferred StockStocks and bonds remain the most common and easily accessible forms of investing available to

personal investors. There are options that exist for both stocks and bonds with perpetual bonds,

common stocks and preferred stocks being the three most sought-after investment vehicles,

because they are the most readily available, and the initial investment for all three is attainable

for even the smallest of investors.

1. Types

o A perpetual bond has no maturity date, which means the bond and the investment

will remain in effect until the bond holder decides to liquidate the bond. Investors

prefer perpetual bonds for their stability and longevity. Investing in a perpetual

bond is a long-term form of investing.

Common stock is the stock and shares of ownership issues by a company that is

public. A public company sells shares of the company to investors and in return

the company reports on business performance on a routine basis. Common stock

owners also receive dividends on stock shares, which is a division of business

profits.

Preferred stock is similar to common stock, but the main difference is that

preferred stock holders are paid dividends before common stock owners.

2. Features

o The most noticeable feature of a perpetual bond is stability in the investment.

Market fluctuations do not affect perpetual bonds once the investment has been


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made. The bond continues to earn the same rate of interest and return as it did

when the bond was initially purchased. Low-risk investors prefer this feature.

Common and preferred stocks are moderate to high-risk investments that allow

investors to be actively involved in investing. Buying, holding and selling stock is

a way that investors can change their return on investment. For example, holding

shares of stock in a company where the stock price does not change much offers

moderate-risk investor the ability to maintain her financial position. Higher-risk

investors can move in and out of stocks quickly if they choose to.

3. Benefits

o The primary benefit of perpetual bonds is the low risk associated with them.

Perpetual bonds have a lower interest rate associated with them compared to other

forms of investing; however, this is a benefit for an investor who does not want to

risk his investment.

The main benefit of common and preferred stocks is the opposite of perpetual

bonds. Market fluctuations and constant stock price changes provide investors

with the opportunity to increase their earnings through buying stocks at a low

price and selling them at a higher price. There is more involvement and

understanding on the end of the investor as monitoring stock holdings and

knowing when to sell is the key to recouping your initial investment plus making

a profit.

4. Potential

o The potential of perpetual bonds in terms of investment strategy is that income is

routine and forever, which means that gauging income received from the bond is

easy to calculate and market conditions will not affect what the investor receives

as income.


Stocks, both common and preferred, have the potential to earn investors large

gains in income if the stocks are selected carefully and thus bought and sold at the

right time. The potential exists to make investments in stocks that provide returns

on investment of 100 percent to 200 percent. Stocks, both common and preferred,

issued during an IPO (initial public offering) hold the greatest potential in terms

of large gains being made.

5. Warning

o Perpetual bonds should be used as a long-term, low-risk strategy. A warning for

investors is to make sure that perpetual bonds are not their only form of

investment. Due to the lower rate of return, investors will maintain their current

investment amount while making a slight income on revenue. Stocks, both

common and preferred, should be invested in cautiously as stock prices can not

only rise, but also fall.

ConclusionIn summary, a perpetual bond is a bond that doesn't have to pay back by the issuer, but does pay

a fixed interest. In this, it is a bit like a share and a bit like a normal bond. Its risk is between that

of a share and a normal bond. As it is a fairly complex product with a pretty asymmetric risk

profile, it's best for advanced investors. The bond market is deep and offers investors a variety of

bonds to purchase. Besides fixed-rate securities, investors can invest in inflation-linked bonds,

floating rate notes, zero coupon bonds and perpetual bonds that have no maturity. A state or local

government issues municipal bonds. The benefit of these bonds is that the interest payments are

exempt from federal taxes and the taxes from the issuing state.


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Perpetual Bond