Financial Structure and Bonds

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to Specific investments.

by HOWARD DOUGLAS DOZIER

ONE sultry August morning in 1929, I made a round of the principal bond houses in that Middle-Western city which calls itself the Heart of America, in search of investment information. In the half-dozen offices at which I called I saw exactly one person other than employees, and he did not look like a prospective bond buyer. That afternoon I did the stock brokerage places, found them crowded to the doors, and saw wedged in along with the rest most ot the bond salesmen I visited during the morning.

At that time $100 of investment money would buy anywhere from $5.00 to $5.50 of good corporate bond interest per year, and only slightly less of the safest to be had. The same money would buy only about half as much of common dividends. Indeed, in some cases it took more than $100 to buy no common dividends at all, dividends which up to that time had never been paid and have not since.

The best corporate income could then attract few buyers even at bargain prices; the worst found plenty ot takers, and at fabulous figures. A reversal ot the natural order such as this brings opportunity to investors who habitually think in terms of income — opportunity to increase both the quantity and the quality of their income by selling common stocks and buying bonds. Of course, then as always an investor must use discretion in the selection of the bonds to be purchased. In a way it is a harder job to buy bonds than it is to buy common stocks. The common dividend buyer is skating on ice honeycombed with air holes, and he knows it; the bond interest buyer must make his way amid great patches of thin ice which looks as if it would hold but won’t. Since 1922 nearly five thousand bond issues have defaulted on their interest on well over seven billion dollars in par value. The purpose of this paper is to call attention to some of the considerations that should be observed by the interest buyer.

It is imperative to keep in mind that a bond in its simplest form is a promise to pay — a twofold promise to pay, first, one lump sum on a given date in the future, and second, smaller but equally definite amounts periodically in tbe meantime. What one buys is this whole bundle of promises wrapped up together in a highly legal and beautifully engraved document. What he gets is the ability and willingness of the maker to keep his word, the former characteristic a matter of finance, and the latter a simple matter of corporate honesty. Neither legal nor mechanical embellishments change these fundamentals.

He who sets out so to inform himself that he can trust his own judgment in making his commitments will of course get all the help he can from his banker or other reputable investment counsel and from the various good manuals now available, but he will never surrender his own independent decision to either men or manuals. To do so is a fatal species of financial fundamentalism. Perfectly good advice from the point of view of him who gives if may be horribly bad from that of him who takes it.

Any good manual will give the investigator a start. Manuals classify bonds into categories and earmark them with distinguishing symbols in accordance with their quality. The one open in front of me now rates as Aaa those which meet the highest tests as to asset value, earning power, and stability, and as C those which rank hardly higher than good speculations. These generalizations of experts will assist one who proposes to reach his own conclusions by way of his own investigations, but they will not satisfy him on many points which he and he alone must decide.

For instance, there is the matter of nomenclature. Rond names are almost as numerous as the sands of the sea. Two or more may bear the same name and be of different, quality, or different names and be of like quality. In fact, one bearing an unpopular name may prove to be better than another bearing a popular one. A debenture and a first-mortgage bond will illustrate the latter point. We here in America, accustomed as we are to emphasize property itself more than we do its income, are inclined to set too much store by the two words ‘first mortgage and too little by tbe one ‘debenture.’ A debenture, which is far less popular in this country than in England, may in reality be better than a first-mortgage bond, as I shall point out presently. A debenture may furnish just the type of income suited to the peculiar circumstances of a particular investor. Analysis and not hearsay must determine.

The mortgage clause in a bond is a sort of prearranged and preagreed-upon penalty according to whicli the holder may lay hands upon a corporation’s property if the issuing corporation defaults on its bond interest. But the power to lay hands upon property is frequently of questionable advantage, and the laying on of hands, in many eases, proves a positive disadvantage to creditors. Recourse to taking possession has often meant foreclosure, out of which has grown receivership racketeering.

It is just as erroneous to look upon all non-mortgageseeured bonds as bad as it is to think of all first-mortgage bonds as good. Debenture bonds are plain notes of hand of a corporation, and arc based upon its general credit. They may be very good or very bad: good because the issuing corporation is so reputable that it can borrow the money it needs merely upon its word, or bad because the corporation’s income available for interest payment has already been eaten into by as many mortgage bonds as can be plastered on its property, and because its financial state is thus brought so low that as a last resort it has to sell in the form of debentures what little credit it has left at whatever it will bring. Generally, debentures have at least one advantage over even first-mortgage bonds. If a corporation does not and cannot meet its debenture interest when due, it may postpone it, let it accumulate like any other indebtedness, until it has an opportunity to work itself out of the difficulty. Frequently this is better than foreclosure. Second-mortgage bondholders may throw a corporation into receivership and cause the first bondholders trouble even though neither their principal nor their interest is jeopardized.

So it comes down in the end to this: wherever a real investor starts, he ends up with an analysis of income, the net operating income of the corporation whose bonds he is considering and his own claims as a bondholder to his portion of the corporation’s earnings. Such an analysis leads him inevitably to a study and dissection of financial structure.

Let us now take two corporations of different financial structures and compare the situation of an investor in flic first-mortgage bonds of one with that of an investor in the debenture bonds of the other.

CORPORATION A

First-mortgage 5% bonds $1,000,000

Second-mortgage 6% bonds 2,000,000

10,000 shares common stock 1,000,000

Total capitalization $1,000,000

If in a given year this corporation should have left a net operating income of $400,000, after all operating expenses, it could pay its first-mortgage bond interest of $50,000 eight times over. When it had paid its interest it would have left $350,000, which is ordinarily spoken of as the margin of safety of the first-mortgage bonds. To be sure, this belongs to the other bondholders and the common stockholders, but their claims do not run against it until the first-mortgage interest is paid. Out of this $350,000, the corporation could pay the second-mortgage interest nearly three times. When the corporation had paid its second-mortgage interest there would remain $230,000 for the common stockholders, though they have no claim against this so long as the second-mortgage bond interest remains unpaid.

But earnings vary, and, should they be halved, the first-mortgage interest would be earned four times and would hardly be in danger, for there would still remain a margin of safety of $150,000. Of this amount $120,000 would be requited to pay interest on second-mortgage bonds. This interest would be earned only slightly more than once, and some question would be raised as to the probability of a continuation of its payment. Should earnings continue to fall, second-mortgage interest would eventually be defaulted, and this class of bondholders could take possession of the corporate property to the probable great inconvenience of the first-mortgage bondholders, although their position might not be endangered.

Should a company such as Corporation A get into financial straits and need money, it would probably resort to debenture bonds subject to its firstand second-mortgage issues. Such debentures would be mere specula I ions.

Let us look into this matter of debentures in the case of another company which we may call Corporation B

CORPORATION B

5% debenture bonds $1,000,000

30,000 shares common stock 3,000,000

Total capitalization $4,000,000

This corporation has a financial structure of one fourth bonds. Its credit is so good, when it needs money, that it can gel what it wants without mortgaging its properties. The probabilities are that it has included in its debenture contracts a provision which prohibits it from mortgaging its property except by consent of the debenture bondholders. One who is thinking of buying debenture bonds should be very careful to see whether the contract under which they were issued contains this provision.

If this corporation has a net operating income of $400,000 a year, it is said to earn its interest eight times. It is in such a strong financial position that it could suffer a decline in earnings of $350,000 in a year before having to draw upon its surplus to meet current bond Interest. Even if it should run into financial difficulties, there would be no inferior bondholders clamoring for their interest and causing embarrassment.

So in the end the investor, as distinguished from the specula tor, should always wind up with a study of income in its relation to financial structure. A right conclusion as to what interest income to buy depends upon painstaking analysis rather than upon platitudes and pseudofinancial philosophy. Having followed such an analysis, the investor need not be surprised if in some eases the first have become hod and the last first.