The Covid pandemic has caused governments of all levels around the world to take on huge amounts of extra debt as they face dwindling tax income and the need to provide fiscal stimulus to boost their economies. Fortunately, demand for yield has made issuing bonds relatively easy. Yields continue to fall towards record low levels despite the growing debt pile.
However, for issuers such as governments, it is always worth looking at the potential risks to their debt profile as well as exploring ways to diversify it further.
The demand for yield has created an opportunity for issuers to extend the maturity of the bonds they are selling and that is definitely a positive for them. But perhaps now is also a good time to explore a type of bond that is rarely used by governments, namely Perpetual Bonds.
Perpetual Bonds are bonds with no set maturity. The issuer pays the coupon, theoretically forever. In the distant past, both the UK and US governments issued Perpetual Bonds usually to pay for wars. More recently, some banks have sold them although often they are at a subordinated level. The perpetual nature means that typically, investors will only buy these bonds from very stable, safe issuers. As one of only a few AAA-rated issuers, Australia would definitely fit that profile.
The benefit for the issuer, say a government, is that they do not have to provide for repayment of the bonds in future. For example, a typical 10-year bond will need to be bought back after 10 years and typically the issuer has to provision for that.
In addition, issuing some Perpetual Bonds will reduce future reliance on going back to the bond market to either fund repayment of retiring debt or new debt. Right now, the bond markets may be very willing to buy this huge amount of debt at cheap levels but we can’t be sure the same will be true in say five or 10 year’s time. Further, Australia is not the only country or issuer to have built up a high debt burden. Global debt has skyrocketed this year. So, the potential for a future shock for issuers has likely increased even if it remains small.
Some Perpetual Bonds have provisions to be called (redeemed) in certain circumstances and the issuer may want to include these. However, such features may reduce the attractiveness of the Bond to investors.
Perhaps the main drawback from an issuer’s perspective right now is the possibility that interest rates become negative. Indeed, there are an increasing number of negative yielding bonds. Issuers may feel that if they can get paid for selling bonds why would they issue Perpetual Bonds that pay some interest?
However, I am not suggesting that the government issue a majority of their debt as Perpetual Bonds, just a portion.
For investors, Perpetual Bonds offer stable and predictable returns, potentially forever. They are easily priced and valued and can form a part of a balanced bond portfolio. Some investors view them more like an equity product for unlike ‘normal’ bonds they are not repaid at a set date. In some ways, this makes Perpetual Bonds another form of diversification.
In recent times George Soros has been advocating that the EU should consider issuing Perpetual Bonds and it is likely that some other countries are mulling this over. As always, there is probably merit in being first or at least early to market.
In summary, given the significant amount of new debt that Australian governments of all types have built up, it may worth exploring whether now is the time to issue some Perpetual Bonds. The pandemic, like wars, is the kind of event that would trigger such a move. An event that wasn’t planned nor wanted that has caused government to take on more debt than it would have wanted. The government would be locking themselves into paying record low yield on at least a portion of their bonds, potentially forever. This part of their debt would be protected from any future rise in interest rates. Any such future rise in interest rates would mean that future bond refinancing would incur higher interest payments.
While Perpetual Bonds are an unusual form of bond issuance, perhaps unusual times call for unusual solutions?