What it means
Subordinated means the loan sits lower in the queue for repayment. If the borrower goes bust, senior creditors such as banks and bondholders are paid first, and subordinated lenders receive whatever is left.
Perpetual means the loan has no fixed maturity, so the borrower pays interest indefinitely. These loans are common in banking.
Regulators allow banks to count certain perpetual subordinated debt as regulatory capital, because it can absorb losses and has no maturity date that might force the bank to repay at a bad time. Interest can sometimes be cancelled or deferred in stress, which makes the instrument behave partly like equity.
For the borrower the attractions are long-term funding, lower dilution of ownership than issuing shares and, in many cases, interest that is tax deductible. For the lender the attraction is a higher return than senior debt.
Because the cash flows stretch on forever, the value of the loan is highly sensitive to interest rates and to the borrower's credit quality. Most perpetual loans have a call option allowing the borrower to repay after a set period, such as five or ten years.
If the borrower does not call, the interest rate may be reset, either to a higher fixed rate or to a floating rate. Investors therefore price the loan on the assumption that it will be called at the first date, and a failure to call can alarm the market.
The nuance is the risk of loss. The lender may suffer a write-down or conversion into shares in a crisis, and interest may be suspended without default.
These loans are suitable only for investors who understand that the high yield pays for real risk.
In practice
Real-world examples.
Example
A mid-sized bank issues $100,000,000 of perpetual subordinated debt to strengthen its capital ratio. The regulator treats it as additional capital, so the bank can lend more without raising new shares. The loan also gives the bank a stable layer of funding that does not fall due in a downturn.
Example
An insurance group raises long-term funding through a perpetual subordinated loan from a pension fund. The pension fund accepts the higher risk in return for a yield well above that on senior bonds. The fund manager checks the issuer's credit rating and capital position before investing.
Example
A credit analyst compares two issues from the same bank, one senior and one perpetual subordinated. The subordinated loan pays 3 percentage points more, reflecting the larger loss the lender would take in a failure. She advises clients to compare the extra yield with the extra risk before buying.
Formula
Calculation
Annual interest = principal x interest rate
Value of the loan as a perpetuity = annual interest / required yield
Suppose a bank issues a $20,000,000 perpetual subordinated loan at 7%. Annual interest is 20,000,000 x 0.07 = $1,400,000. If investors demand a yield of 8%, the loan is worth 1,400,000 / 0.08 = $17,500,000. If investors demand only 7%, the value is 1,400,000 / 0.07 = $20,000,000, which equals the principal.Case study
Seen in the real world.
Harbourline Bank is an illustrative, fictional lender that needed to raise its capital ratio ahead of a planned expansion. Issuing new shares would have diluted existing shareholders, so the treasurer proposed a $40,000,000 perpetual subordinated loan at 7.5%.
The annual interest cost was 40,000,000 x 0.075 = $3,000,000. The regulator agreed to count the loan as capital, which let the bank raise lending by many times that amount.
In the first call year, market yields were higher, so Harbourline decided not to call the loan and instead accepted the reset rate. The illustrative lesson is that a perpetual loan gives flexibility in good times and a lasting cost if market conditions change. The treasurer now reports the call date and reset terms to the board every year, so that the choice is made with open eyes.
Watch out
Common mistakes.
- Thinking perpetual means the borrower will never repay, when most loans have a call option and the market expects it to be used.
- Treating the loan like senior debt, when the lender is paid after other creditors and may suffer write-downs.
- Ignoring the reset rate after the first call date, which can raise or lower the cost.
Questions
People also ask.
Why do banks issue perpetual subordinated loans?
They provide long-term funding that regulators may count as capital, without issuing new shares.
Is a perpetual subordinated loan debt or equity?
It is debt in legal form, but because it ranks low and has no maturity, it shares some features with equity.
What risks do lenders take?
They face credit risk, interest rate risk, the chance that interest is suspended and the risk of write-down or conversion to shares in a crisis. Lenders also face the risk that the price falls sharply if the market doubts the borrower will call the loan.
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