When there is no need to repay

The bulk of government borrowings are through the issuance of bonds that have a tenor of anything under a year to over ten years. Interest is paid at the coupon rate on the face value while the market value of the paper varies in consequence to the movement in interest rates. But bonds have to be redeemed at the end of their life, as subscribers need to be paid back. The aggregate value of bond issuances is reflected in the sum of government borrowings, frequently presented as a share of GDP. If the debt to GDP ratio exceeds a certain value, rating agencies stir up to change their outlook to negative and eventually an ratings downgrade that influences both the cost and flow of foreign funds into the country. This did indeed happen earlier this week, when Moody’s downgraded India’s sovereign rating from Baa2 to Baa3, the lowest in the investment grade category.

One option that governments consider, specifically in times of a crisis such as the one we now face, is Perpetual Bonds. As the name suggests these instruments have no redemption date and are effectively offered in a way that interest is paid in perpetuity. In a way, therefore, they are not dissimilar to equity, where dividends are disbursed each year. But the fact is money loses value over time because of inflation and consequently, in order to seem attractive to investors, the coupon rate on the offering must exceed the rate of inflation. Effectively, Perpetual Bonds are another way to monetise the fiscal deficit. There are clever techniques to make such offerings attractive; for instance, inherent in the structure could be a periodic interest rate increase after say five or ten years, or where the coupon rate is inflation-linked, etc. The Government can place a call option to redeem the bond, if it considers appropriate. It is unclear as to the treatment of these bonds on the balance sheet of the government and possibly unlike routine treasury paper, the principal of Perpetuals need not reflect in the cumulative debt obligation of the government, as they never actually need to be redeemed. 

The Buttonwood column in The Economist explained what John Cochrane of the University of Chicago proposed as to how perpetual bonds could be structured. The first option could be to offer a bond with a fixed value of USD 1 forever and a coupon rate of that could be linked to the overnight bank rate. The second, could be a fixed coupon payment of USD 1 forever and a price that is determined by market forces. The fixed value floating rate bond would be very liquid and meet the warrants of a trusted and safe security. The fixed coupon instrument would have the character of long-term debt that is attractive to pension funds and life insurance companies. 

The over-riding advantage is one of liquidity, which is not really the case in normal treasury paper. The total quantum of sovereign debt has hundreds of different securities of varying interest rates and maturities. For instance, a 10-year bond offering in the first year becomes a 9-year bond in the next. The more bond offerings there are, the less liquid each one becomes. Perpetual bonds, on the other hand, are identical. The draw-back is credit risk. If a country defaults on a normal treasury bond, the investors are paid back a certain portion of their investment. Perpetual bonds have no principal and therefore only the most spotless issuers can be trusted with them. The Government of India might wish to consider these and even offer them to overseas investors. In fact, Dr Cochrane goes so far as to suggest that Perpetual bonds should replace other forms of offering as they can be structured to provide both liquidity and long term debt. But that is not a widely accepted hypothesis. As a start, a small test offering is the way to go.