Companies and governments issue debt as a means of raising funds to finance initiatives or growth. These entities may issue notes, bonds or other debt at various interest rates for various lengths of time. This debt is classified as redeemable and irredeemable. Irredeemable debt is perpetual. In theory, the loan or bond is never repaid so the debt buyer benefits solely from the interest payments he receives.
Irredeemable debt is debt that has no specific redemption date or maturity period. The issuing authority or entity pays a specified interest rate periodically but provides no data on when principal will be returned. In many cases the principal is never paid. The United States Treasury does not issue irredeemable debt. But other national governments and state and local governments do, typically as bonds or debentures, as do companies. Another name for irredeemable debt is perpetual debt or consol.
As long as a company or other issuing entity does not default on the debt and pays the coupon rate as noted, the coupon payment can theoretically extend forever on irredeemable debt. The issuing entity is responsible for the coupon payments. Therefore, if it defaults, the principal on the bonds will come due. Some such bonds are callable at specific points in time. "Callable" means the issuer has the right to return the investor's principal in the bond and cease all coupon payments. Companies sometimes insert this option to allow themselves an out if the interest rate drops precipitously. This call option enables issuers to significantly reduce interest costs.
To get an idea of how a callable bond works, suppose a company has $50 million in irredeemable bonds outstanding with a coupon rate of 8 percent, slightly more than the prevailing interest rate at the time of issuance. The interest rate steadily drops over a period of time to 5 percent. The company is currently paying $4 million per year in interest payments. A new coupon rate of 5.5 percent would drop the annual payments to $2.75 million per year, a savings of $1.25 million annually. The company calls the bonds at the five-year mark and re-issues similar irredeemable debentures later in the year at the lower coupon rate.
Many issuing entities use perpetual bonds as subordinated debt. They often treat their perpetual bonds similar to preferred equity since they do not need to repay the debt. Perpetual bonds typically offer a higher coupon rate than that offered by comparable, redeemable bonds. This higher rate factors in the lack of redemption and captures any embedded call option.
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