Perpetuities and Credit Risk
Perpetuities and credit risk are closely related concepts, due to the indefinite nature of the cashflows accruing from owning a perpetuity. Most individuals or corporate organizations that invest in perpetuities do so largely based on the expected continuous stream of income it provides.
Hence, investors in perpetuities usually consider the credit risk rating of the issuer before investing. This is because governments or companies who issue perpetuities have to keep paying the investors indefinitely and their ability to keep paying is largely determined by their credit risk rating.
Read about: Perpetuities and Interest Rate Risk
Meaning of perpetuity
A perpetuity is a type of investment that pays the investor a fixed or growing amount at specified intervals without ever stopping. The former is known as a fixed perpetuity while the latter is known as a growing perpetuity.
The cashflows from perpetuities are usually paid annually although some perpetuities may be paid quarterly or monthly. The frequency of payments is mostly determined by the type of perpetuity and the terms of the perpetuity contract.
Common examples of perpetuity include consols, preferred stock, endowment funds, common stock, charitable remainder trusts (CRT), and payments from rent on land or rental property.
Consols are one of the oldest forms of perpetuity which pay their holders a specified coupon rate at regular intervals and do not have a maturity date. They were majorly issued by the United States and the United Kingdom governments to sponsor wartime expenses and major projects.
The dividends from preferred and common stocks are also perpetual provided they are dividend stocks. This means the issuing companies are obligated to consistently pay dividends to their shareholders. The dividends from preferred stocks are usually fixed while those from common stocks are not fixed.
Endowment funds and charitable remainder trusts (CRT) are mostly used to sponsor scholarships, college chairs, and charitable causes. These are organized as perpetuities so that they can keep providing continuous cash flow for the causes they support.
Before investing in perpetuities, most investors determine the perpetuity’s value using the present value of a perpetuity formula. This helps determine if what they are paying for the investment, its market price today, is worth the investment.
The formula is additionally useful in determining the present value of a company’s future cash flows and for understanding the value of lease payments that will be received for rental land or property.
Read about: Perpetuities and Derivatives: Differences and Similarities
What is credit risk?
The credit risk to a lender includes the possibility of losing both the principal invested as well as the interest that should be received on the investment. Additional risks include increased credit collection costs and the disruption of cash flows accruing from the credit.
The lender’s risk may be partial if the borrower can eventually continue interest payments or repay the loan. It may be a complete loss if the borrower is unable to repay, especially in cases of bankruptcy.
Credit risks arise due to several reasons such as:
- Failure of a company or individual to pay an invoice when due.
- The inability of a government or organization to pay back the bond principal at maturity or its inability to make regular coupon payments.
- An organization’s inability to pay its employees earned wages when due.
- A consumer’s failure to make a payment due on a line of credit, mortgage loan, credit card, or other loan.
- A company’s inability to repay asset-secured fixed or floating charge debt.
- When a government grants bankruptcy protection to an insolvent consumer or business
In an efficient market, higher levels of credit risk are associated with higher borrowing costs. This implies that if there are two lending opportunities, the one with a higher credit risk will also have a higher borrowing cost.
For instance, if Abigail and Grace want to borrow money from Joe’s Financial Services and assume that Abigail earns a steady monthly income from her job while Grace is unemployed and depends on her family and friends for survival.
If Joe’s Financial Services operates in an efficient market, they may charge Abigail a borrowing cost of 10% and charge Grace a higher borrowing cost such as 15%. The difference in borrowing cost is based on their perceived ability to repay their loans.
Even though accurately determining who will default on credit is not always possible, when lenders properly access and manage credit risks, it often lessens the probability of lending to a borrower who may default.
Lenders mainly manage credit risk by using measurement tools to quantify the risk of default and using mitigation strategies to minimize losses when borrowers default.
A common metric used by banks in measuring risk when they provide loans to individuals or corporate organizations is the five Cs of credit. This includes the person’s or organization’s credit history, loan conditions, capacity to repay the loan, associated collateral, and capital.
This provides the bank with insight into how easily a borrower can repay their debt or the possibility that they may default.
Read about: Delayed Perpetuity Examples and Types
Perpetuities and credit risk
As we have seen so far, perpetuities are investments that provide a guaranteed income source for investors while the credit risk is the possibility of default on the part of the perpetuity issuer to keep up with payments to investors.
For investments such as perpetuities, interest payments from the government or organization that issued the perpetuity are the investor’s reward for assuming credit risk.
Before investing in perpetuities, most investors consider the credit rating of the issuing company. Credit rating companies, such as Fitch Ratings and Moody’s, Standard & Poor’s (S&P) assess a company’s ability to keep up with credit payments using letter grades.
Although their rating systems differ to some extent, A grades are better than B or C grades, and triple or double A grades are better than single A grades. The lowest grade is the D grade.
The Fitch rating uses the triple-A grade ratings to denote issuers that have the lowest expectation of default risk. It is assigned only in cases of exceptionally strong capacity for payment of financial commitments. Generally, companies that get the triple-A grade are highly unlikely to be adversely affected by foreseeable events.
The D grade is used to denote issuers that reached a winding-up stage such as liquidation, bankruptcy filings, receivership, administration, liquidation, or other formal winding-up procedures. It is also used to denote a company that has otherwise ceased business and debt is still outstanding.
Due to the infinite nature of the cash flows that may accrue from perpetuities, the credit risk of perpetuities is considerably high. This is because several factors could make the government or organization default on their obligations.
For example, when the British government issued consols in the 18th century, they were meant to provide annual coupon payments to the consol holders forever. However, in 2015, the British government decided to redeem all the consols they had issued.
Although the consol had provided coupon payments to its holders through three different centuries with most families benefiting from the investment made by their forefathers, its eventual redemption ended the supposed guaranteed income that beneficiaries were getting.
Additionally, when a perpetuity issuer goes bankrupt, the investor loses both their principal investment as well as the interest payments that they are supposed to receive.
Hence, the credit risk of perpetuity is exacerbated by the lack of a maturity date when the principal will be repaid as well as by the possibility of the issuer going out of business as time passes.
Additional changes that pose additional risk for investments in perpetuities include changes in government or financial policies that may not support perpetuities or in the case of government issuers, the government’s deciding to discontinue interest payments and redeem the perpetuities.
Read about: Assumptions of Efficient Market Hypothesis (EMH)
Conclusion
Every investment has its associated risks, for perpetuities, credit risk is one of its associated risks. This risk of default on the part of perpetuity issuers is mostly due to the long-term nature of payments accruing from perpetuity.
Additionally, other unforeseen circumstances that may arise in time such as changes in government policies and the issuer’s inability to keep up with payments due to bankruptcy also contribute to the overall credit risk of perpetuities.
