What is an irredeemable debt? Definition, Explanation, Examples, And More

Definition

Irredeemable debt stands for debt with no maturity date and pays regular interest rates for an unlimited time.

Theoretically, we presume that the debt’s nominal (par) value is never reimbursed to the debt holders. Instead, they get in return a benefit from an infinite number of coupons or interest payments. Irredeemable debt is also known as a perpetual debt or consol.

Explanation

Irredeemable debt instruments are an attractive funding option for companies as they are not required to redeem the debt. This non-redemption is the reason why they are treated as equity rather than debt on the balance sheet. Investors can carry on receiving interest forever.

Perpetual bonds: a bit of theory and history

The first irredeemable debt instrument appeared in the 18th century when the United Kingdom converted all outstanding issues of redeemable government stock into one bond. Since then, the UK government has repeatedly issued perpetual bonds called consols. For instance, consols were issued in the early 20th century, in the 20s and 30s.

According to Bloomberg, the last console was issued in 1946. The aggregate volume of irredeemable bonds now in circulation totals 2.66 billion pounds, an insignificant amount compared to the global perpetual bond market. Besides the UK, irredeemable bonds were issued by British municipalities, among other countries, by Belgium.

Callable Option in Irredeemable Debt

Most recent irredeemable debt instruments issues have built-in a possible redemption by the issuer after a specified period.

This flexibility protects the issuer from being locked into a high-interest rate when rates have decreased and protected the investor from committing to an unattractively priced asset for an indefinite period. In theory, all issued irredeemable bonds can circulate indefinitely, and the issuer is not obliged to redeem the principal and only pays a regular coupon.

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However, most issues have a call option. For example, the British consol issued in 1932 was callable on January 30, 2013. Call-option influences the risks and investment prospects for perpetual bonds. As long as there is no default on the debt by the issuer, and it pays the coupon rate as agreed, then hypothetically, the payment of the coupon can extend endlessly on irredeemable debt.

The responsibility to settle payments of coupons lies on the issuing entity. Thus, in case of default, the principal of the bonds will become due. Such bonds, at specific points in time, are Callable. It means that the investor’s principal in the bond may become payable, and all coupon payments terminated at the issuer’s right.

Occasionally, issuers insert this option to permit themselves a way out if the rate of interest decreases precipitously. With this option, the issuer can significantly reduce interest costs.

Risks Associated with Irredeemable Debt

Following are the risks associated with irredeemable debt:

  • Interest risk, i.e., price volatility of perpetual bonds as a response to changes in interest rates will always be higher than the volatility of term bonds, all other conditions being equal;
  • Call-option means that the price will increase at a slower pace amidst falling interest rates than bonds without call-option.

Let’s give an example to illustrate the point.

The price of any perpetual bond with a call-option is calculated as follows:

P = P0 – C, where

P is the price of the bond with a call-option;

P0 is the price of bond without call-option;

C is the call-option price.

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Amidst yield decline in the market interest rate, the probability also increases that the issuer will exercise the call option. In effect, the call-option price grows as well, deterring bond price growth. Therefore, amidst falling interest rates, price growth is limited for bonds with call options. 

Example of Callable option

To get a thought of how an irredeemable bond works, suppose a corporation has $100 million in irredeemable bonds with a coupon rate of 10 percent. The rate of interest steadily drops over a period to 5 percent.

The corporate is currently paying $10 million per annum in interest payments. A replacement coupon rate of 5 percent would drop the annual payments to $5 million per annum, a savings of $5 million annually. The organization calls the bonds at the five-year mark and re-issues similar irredeemable debentures later within the year at the lower coupon rate.

Big Business Are Turing to Irredeemable Debts

The post-2008 liquidity crisis has caused a significant shake-up in the way businesses find the cash to run their businesses and presents a particular problem to the world’s largest trading companies, whose models – and funding requirements – changed radically over the preceding ten years.

Large companies’ consolidation has led to corporate giants with a growing need for finance when it is in chronic short supply. Many of these companies were initially brokers of physical transactions, intermediating the movement of crops or metals between suppliers and consumers.

But over the years, they put roots into these commodity markets. To secure a consistent long-term supply of the commodity or a reliable long-term buyer, they bought assets themselves.

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These changing business models led to changing funding requirements. Acting as a middleman tends to be a low margin, high volume, low-risk business model, but owning mines and refineries is very different and capital-intensive.

The solutions adopted by these companies can offer an exciting proposition to investors looking for income in a low-interest-rate environment. They do not present a straightforward commodity play as most large trading companies – even those that own commodity-producing assets – tend to have overall balanced books, if not by matching physical purchases and sales, then by hedging on commodity exchanges.

Notably, bond prices and bond yields are inversely related; i.e., the lower the bond’s price, the higher its return. This is because the actual amount of interest (coupon amount) stays constant. So, if the bond’s price falls, the interest represents a higher proportion of the price.

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