Perpetual motion

PLATFORM: It's all in the name really, isn't it? Perpetual bond. Short, snappy and accurate.

Most people, even those who aren't intimately involved with financial services, have an idea about bonds. They're generally supposed to be safer than stocks, mainly because many of them are issued by governments in order to borrow money.

They usually pay a fixed rate of interest and they can mature from a year to 30 years or longer. Sometimes they don't mature at all, which means that you've lent money forever. In perpetuity. Which is where the perpetual bond, or Perp, comes in.

The method of valuing bonds of any maturity is simple. You look at the fixed rate of interest and compare it with current interest rates. If your bond pays 4 per cent and interest rates are about 2 per cent, the bond becomes more valuable. If interest rates are at 6 per cent, however, your bond is less valuable.

The price of the bond, therefore, reflects this difference which is why when interest rates go up, bond prices go down. If you don't sell the bond but hang on to it for whatever length of maturity it runs to, then you will have earned whatever the coupon rate is regardless of what day-to-day interest rates have done in the meantime.

Most bond portfolios will be showing losses in the current rising interest rate environment.

Perps, however, don't mature at all, so the only way that you will get your money back is to sell them to someone else. And the price they will pay reflects all of the issues above, as well as the fact that they are buying an illiquid instrument. By their nature, Perps are less liquid than bonds with fixed maturity dates.

Because of this they usually pay a hefty coupon rate and, because of this illiquidity, the buyer must feel comfortable the issuer isn't going to go bust. Ever.

None of this is particularly difficult to grasp which is why I am astonished at the current furore over the holdings of perpetual bonds by credit unions and the suggestion that they night have been "missold" to them by Davy Stockbrokers.

Credit unions, which try to portray a warmer, fuzzier image than the banks with which they compete, should nevertheless have known what was involved in putting a Perp on the books.

The annual or semi-annual income stream would be high but the value of the asset, the bond itself, would fluctuate as interest rates fluctuated.

It could also fluctuate as the fortunes of the issuer fluctuated, since the exposure of the investor is entirely to the issuer.

Until the ECB began hiking interest rates, holders of Perps were sitting pretty. They were getting an income stream at a much higher level than would be generated by conventional bonds and, because interest rates had been falling, the value of their bonds would have been rising too. So it was a win-win situation.

Now the income stream remains the same but the asset value has depreciated which means showing a substantial loss on the portfolio. If interest rates fall again, the value of the Perp will go up once more.

Whether Perps are suitable investments for a credit union is a question for the organisations themselves but it is inconceivable that someone in charge of investing funds on behalf of a credit union wouldn't have a basic understanding of the fundamentals.

The Irish League of Credit Unions website assures members that the savings protection scheme - which also invested in Perps - protects the individual savings of members by making sure the unions are financially and administratively sound.

Credit unions also offer financial advice. It seems that they should have taken some lessons on investment products themselves first.

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