Bonds and Preferred Stocks

Is it so nominated in the bond?—SHAKESPEARE

INTRODUCTION

A corporation is a peculiar thing. A corpora­tion, at least in the eyes of the law, is actually a legal entity, having been born by virtue of its charter; it has certain rights and privileges which are conferred upon it by the state which issued its charter, which specifies the total capi­talization and the amount of stock and/or bonds which may be issued; should any further amounts be required, then the charter must be amended. Such rights include the right to issue a portion or all of the total authorized stock and/or bonds specified in the charter, the power to incur obligations (debts) and to issue bonds to cover such debts, the right to own prop­erty, the right of recourse to law for suit or to be sued in turn. In other words, the corporation is an artificially created entity, which has many of the attributes of a person.

BONDS

A bond is basically a contract whereby a cor­poration may borrow money and, in turn, prom­ises to pay interest at a stipulated rate for a fixed period of time. While the stockholder is a part owner in the business, the bondholder is simply a creditor and as such has a prior claim upon the assets of the corporation. In the event of fail­ure of the issuer of the bond to carry out the pro­visions of the contract (commonly known as the indenture), the bondholder is protected by law and may take the necessary steps to recover the principal amount which he has lent; in practice this is done by the appointment of a trustee to act for all bondholders as a group in the event of any legal action. In case of bankruptcy, the claims of any bondholders are prior to all other claims and must be satisfied before stockholders of any class receive anything. Should more than one bond issue be involved, they are usually sat­isfied in the order of their rank or issue.

Bonds are classified in a number of ways. By purpose of issue we may have bridge, highway, terminal, and equipment bonds; by origin we may have railroad, utility, government, munici­pal, and industrial bonds; by type, referring to the bond itself and its various investment attri­butes, we may have coupon, registered, callable, convertible, and sinking-fund bonds. By the character of the lien or contract they may be called secured if they are a direct mortgage upon certain assets; or unsecured if they are based entirely upon the investment repute of the issuing agent; the latter are commonly termed "debentures," and the so-called U. S. Savings Bonds are more properly debentures, since they depend entirely upon the integrity of the Fed­eral government and are not a lien against any of its properties.

The most common denomination in which bonds are issued is that of $1000, although occa­sionally $500 bonds are also offered. In a few cases, such as the well-known debentures of the American Telephone & Telegraph Company, and certain railroad bonds, the $100 bond is also made available. The higher denominations are most commonly employed, because most bonds are sold to large financial institutions or to wealthy individuals in very large amounts, and the costs of printing and handling are much re­duced if the large denomination is employed.

A bond is issued for a fixed period of time, commonly called the term, such as twenty years. It carries a fixed rate o£ interest, such as 4 per cent. This stated rate and term appear as part of the contract, but the rate is essentially not the effective rate, which depends upon the price at which the bond is bought. For example, let us suppose we are dealing with a $1000 bond and a stated rate of 4 per cent, which means that the bondholder will receive $40 per annum, usually in two semiannual installments of $20 each. If this bond was purchased in the open market for $900, then the true yield would be 4.4 per cent, rather than that stated on the bond itself, it be­ing quite obvious that a return of $40 on $900 must be higher than the same return on an in­vestment of $1000. In a like manner, this bond would yield less than 4 per cent if bought for more than its face (par) value. Tables have been constructed which show the actual yield upon $100 for a wide range of purchase prices and for various stated interest rates. They are available at many banks, stockbroker offices, and public libraries.

Most bonds pay the stated return on the in­vested amount semiannually, such as April 1 and October 1; a few pay annually. The actual pay­ment may be made in one of two ways. Coupon bonds pay their interest upon presentation of the current coupon, which is detached and cashed in the manner of a check. In the case of registered bonds, which, as the name indicates, are actually registered in the name of the owner at the issuing office, the interest earned is sent by check twice a year to the owner in the same man­ner in which stockholders are paid. While these are safer, because payment is made to the regis­tered owner and no one else, they are somewhat less marketable than the coupon type. Transfer of title to the latter is quite simple since the bond bears no owner's name.

The price at which a given bond is quoted is usually a reflection of the over-all esteem in which it is held by the investing public. Very high-grade bonds will, as a general rule, command a premium price and as a result will al­ways yield somewhat less than their stated rate of return. Bonds that are priced to provide an unusually high rate of return may be viewed with suspicion, since their low price reflects a considerable degree of speculative element, and this may be construed as a warning signal to the investor. As is the case in all forms of invest­ment, security is closely related to price. This is best illustrated in the case of bonds, because they represent a creditor relationship, and the princi­pal amount, rate of return, and total term are clearly set forth in the contract; bond prices re­flect less of general business conditions than do other forms of corporate securities, because their requirements must be met first and all other claims must be subordinated to them.

While it is true that the price of a bond re­flects its investment repute, we must at the same time realize that that price is determined by a number of rather complex factors. One of the most important of them is the term, or maturity date, of the bond. Long-term bonds usually pro­duce slightly higher yields for two reasons. First, the obvious difficulty of appraising the financial status of the issuing agency so far in the future must be considered at the time of purchase, and the buyer therefore feels entitled to some recom­pense in the form of a slightly higher yield. Sec­ond, prevailing interest rates may and often do change considerably, so that a 32 per cent bond will look even better if money becomes more plentiful and 3 per cent bonds become generally accepted, but this may also work in reverse. A 32 per cent yield may look very attractive at a time when money is quite plentiful and it is not necessary to issue bonds carrying high rates in order to attract investment capital, but it may lose its attractiveness when money has become scarce, so that many 42 per cent bonds are avail­able. The holder of the 32 per cent bond is then faced with a problem. If he holds it to maturity, he will only get the rate of return specified, sup­posing that he bought the bond at par; should he decide to sell, in order to take advantage of the higher return on the later and now current bonds, he most assuredly must take a loss. This is because his bond now does not look so attractive to others since the newer bonds offer higher yields; the older issues will sell for less on the open market, because they are not so much in demand. The fluctuation in the prevailing rate of interest is perhaps the most important item that influences bond prices. Even at the time o£ issue the price may be set above or below par be­cause of the current trend in interest rates. In some cases, bond issues may actually be post­poned because of this condition.

The liquidity of a bond, which means how quickly it may be converted into cash, is of great importance to all investors. With this in mind, it would be wise to invest only in those bonds which are available in goodly amounts, are fre­quently traded, commonly quoted, issued by na­tionally known agencies, and are generally well regarded. If a given bond can pass such a test, it will probably be in demand and thus may be readily salable should an occasion arise when quick conversion into cash is desired.

As a guide to the purchase of bonds, there are available what are known as "bond ratings." These are obtainable from such organizations as Moody and Standard & Poor; in order to obtain a reasonable appraisal of the merits of a certain bond, one need only refer to the rating assigned to it by these or some other reliable organiza­tion. A portion of the ratings of the above two, as applied to better-grade bonds, is shown below:

Moody               S & P        Remarks
Aaa         Al +          Highest grade
Aa           Al High grade
A             A  Upper medium grade
Baa         Bl +          Medium grade

Lower ratings are available, but the investor of modest means will be well advised to confine himself to the better issues. As we have already seen, bonds of good quality are regarded as hav­ing very high investment characteristics, espe­cially with regard to safety of principal.

United States government issues are of two kinds: marketable and nonmarketable. The lat­ter are the "savings bonds," now so well known to all citizens; the former include other govern­ment issues which may be bought, sold, and quoted in the same manner as corporation bonds. Since it is doubtful that the former offer any particular advantages to the small investor, no further consideration of them will be given here.

A bond represents a contract whereby the is­suing agency borrows money and stands behind such a loan by a pledge of property, so that each bond commonly represents a portion of a mort­gage. One might be tempted to think that all bonds are backed by mortgages and are there­fore necessarily the best form of investment. This does not follow, because the general repu­tation of the company, coupled with its over-all financial standing, is of the utmost importance. It is quite conceivable that a company may have the necessary properties to pledge in order to float a bond issue, but the bonds may, at the same time, be very difficult to sell because of the poor operating results and indifferent manage­ment of the company. The mere existence of proper backing of a bond by assets is no guaran­tee that it is of high grade. On the other hand, there is a type of bond called a debenture which is merely a promise to pay, but, because of the high financial rating of the issuing company, may actually be of better quality than many of the true bonds. For example, the debentures is­sued over several decades by the American Tele­phone and Telegraph Company have always en­joyed a high rating, even though they do not carry a mortgage security behind them, as is the case with true bonds. This may be partially ex­plained by the fact that A.T. & T. is one of the industrial giants in our country, has an excellent financial rating, suffers little from competition, has a long and unbroken record of payments on its common stock, and is one of the best-known enterprises in the nation. In addition, deben­tures may be convertible, that is, the holder of such a debenture may, at his discretion, surren­der it with a specified amount of additional cash and receive shares of common stock in ex­change; such exchange must be made within a specified time period and is not a perpetual right. It is obvious that such a conversion may prove quite profitable if A.T. & T. stock is sell­ing on the open market for considerably more than the total amount involved in making the conversion; if, on the other hand, we are in the midst of a low or a declining market so that stock prices are somewhat depressed, it may not pay to make the conversion and the debenture may then be held until redeemed.

Although the afore-mentioned convertible debentures are well known and have proved to be generally satisfactory, this is not the case with many others. If the market price of the common stock, as reflected in its appraisal by the invest­ing public, remains well depressed, the conver­sion feature may never become of any value to the holder.

Bond investment has always been considered as part and parcel of any program; indeed, as has already been made abundantly clear, the pur­chase of bonds may be termed the cornerstone of investment. Good-grade bonds, carrying a rela­tively low rate of return, have had and will con­tinue to possess a high degree of investment sta­bility.

As previously stated, the relation of bond holdings to prevailing inflation and deflation will always justify the inclusion of at least some bonds in any investment portfolio. This is be­cause the bond will entitle the holder to a cer­tain specified income and final principal repay­ment, both of which are very desirable from the investor's point of view. The bondholder occu­pies the position of a creditor, and his rights in that respect are protected by law.

The two possible objections to bond purchase are their relationship to the price level of the dollar (purchasing power) and the fluctuations in prevailing money rates. In spite of the fact that these two items are almost unpredictable, good bonds have always been considered as the most conservative and the lowest risk type of in­vestment. It is significant that the various life in­surance companies, trust funds, and banks invest a considerable proportion of their available funds in bonds of good character. The fact that these agencies, which have available amounts in the millions of dollars, consider bonds so highly is in itself an endorsement of them for invest­ment purposes.

All bonds, as shown in our discussion of bond ratings, are not of equal rank; this is equivalent to saying that all bonds are not necessarily good bonds and that the word "bond" does not neces­sarily carry with it the connotation of high re­gard. Too many people think a bond represents the acme of perfection, the highest among the high in the investment world; a word of caution is in order. In 1929 and the years which followed many bonds became worthless and some others, despite their mortgage provisions, gave only par­tial recompense, and that after a lengthy legal battle.

For the investor of modest means there is per­haps no better buy than the U. S. Savings Bonds which bring a good yield when held to maturity. The argument is sometimes heard that corpo­rate bonds are to be preferred, because they will provide a slightly higher yield 2to 1 per cent higher) than U. S. Savings Bonds. This is true, and recent years have seen the issue of a consid­erable volume of these bonds as a part of post­war expansion but we restrict our statements to the better grades since these seem closely tied to government issues in behavior. The much lower grades, which are severely affected by general business risks and have other speculative charac­teristics, should be avoided.

Bond selection is best made with the aid of the rating, as given by one of the investment serv­ices, and with the assistance of a broker or invest­ment counsel. Some of the matters which should be borne in mind are: (a) type of business (rail­road, manufacturing, public utility) ; (b) bond type (mortgage or debenture) ; (c) term, rate of return, special features (callable, convertible, etc.) ; (d) financial status of issuing company; (e) coverage of interest charges, which should be ample;  (f) relationship to other bond issues.

While bonds are quoted on a day-to-day price basis, they do not characteristically fluctuate as widely as common stocks—at least the high-grade bonds do not; the medium- and lower-grade bonds are subject to rather sharp fluctua­tions, and for this reason are perhaps even inferior to higher grade preferred stocks for the investor of modest means.

No discussion of the investment merits of bonds would be complete if it did not summa­rize the "case for bonds" as against the tendency of many people today to think entirely in terms of common stocks, simply because we have been in the longest sustained high stock market in his­tory. The following items may be pertinent to the case:

1. In poor times stocks may have their dividends curtailed or even omitted, while the return on bonds must be continued in order to avoid reorganization and bankruptcy.
2. In the case of financial disaster the claims of the bondholders must be considered first; all stockholder claims are considered only after all bondholder claims have been completely satis­fied.
3. Bonds provide a hedge against deflation and therefore must be a part of any investment plan.
4. In a depression, when securities paying a good and secure rate of return are much in demand, the price of good-grade bonds tends to rise and will remain high as long as times do not improve.
5. For older people who are anticipating retirement, bond investment offers a certain and secure return which is relatively free  from worry  (except for possible future inflation).
6. There are certain tax advantages inherent in the ownership of certain state and municipal bond issues. For some individuals this may be very desirable.
7. The bondholder is a creditor, while the stockholder is a partner in the business. The latter takes all the risks, while the former has his interest protected by the contract, which guarantees him a stated rate of return, the final return of his invested capital, and a prior claim upon assets in case of financial difficulties.

One further important consideration must be borne in mind. All earnings are taxable in com­puting the corporation income tax liability dur­ing any given year of operations. As we shall see later, the interest requirements of a bonded in­debtedness are deducted from earnings as a busi­ness expense before such tax liability is com­puted; the advantages of this arrangement are quite considerable. This and other matters per­taining to bonds will be discussed in a later sec­tion.

PREFERRED STOCKS

Preferred stock is for those who wish a certain degree of priority in sharing in the earnings of a corporation at a stipulated rate. Preferred stocks are ownership shares with certain special rights; of these the principal one is that of receiving a specified dividend amount before the common shares receive anything at all. It is for this reason that many investors are attracted to this type of security. While it is true that there are various kinds of preferred stock (see below), there are very few exceptions to the rule that there will al­ways be provision for a first claim upon earnings and dividends, although such claims always rank after those of bondholders. Many investors con­sider some preferred issues to be advantageous because of their "first claim" upon earnings and dividends. The articles of incorporation will set forth the number, class, and nature of such pre­ferred stocks and the powers and special rights accruing to such stocks as well. Usually a speci­fied number of preferred shares are authorized, although it is not a requirement that all such shares be issued at one time; it is left to the dis­cretion of the directors to act in this matter as they see fit. Sometimes authorized preferred stocks are issued in series, such as 100,000 series A, followed by 50,000 series B, etc. The par value and rate of return are usually specified in the ar­ticles, but they may be amended under certain conditions. Sometimes there is a provision which protects against dilution by requiring that no ad­ditional preferred may be issued without the consent of the holders of at least two-thirds of the outstanding shares.

We will now turn our attention to the various features of preferred stocks. First and foremost is the matter of the par value of each share. While $100 is fairly common, some corporations, such as industrial and utility, have felt that the investor of modest means would prefer some­thing more nearly within his reach, so that val­ues of $50, $25, and $20 have become more com­mon; in a few cases we may find $10, $5, and even $1 par values. Sometimes there may be a preferred issue which has no stated par value, but the return is definitely stated so that an as­sumed par value may easily be calculated. The market price will be in the neighborhood of this assumed value, depending upon the existing money rates and general business conditions.

The rate of return is based largely upon the projected earnings and also upon prevailing money rates. For example, during the Great De­pression of the thirties, when money was scarce, it was quite common to issue 6 per cent and even 7 per cent preferred stocks. In recent years, when money has been more plentiful, many is­sues have had 4 per cent, 42 per cent, and 5 per cent rates. Notwithstanding the stated rate of return, as in the case of bonds, the market price may cause the actual rate of return to be more or less than the stated rate; in other words, a pre­ferred stock may sell at a premium or at a dis­count, depending upon the value placed upon it by the market place. However, there is one prac­tical limitation placed upon such a price. In the case of an issue subject to call, that is, one that may be redeemed in whole or in part at the dis­cretion of the directors, the call price may set an actual ceiling price on the stock, because no in­vestor will be eager to buy a stock for more than the price at which it may be redeemed. This call feature is of no real value to the investor unless he has protected himself by buying the stock for something under the call price.

Preferred stocks usually have a provision for the regular payment of dividends, there usually being a statement, in effect, that regular quar­terly dividends at the stated rate must be de­clared and paid upon the preferred stock before any payment may be made upon any stock of lower rank, such as the common. In case several series of preferred are outstanding, it is custom­ary to give them a rank such that, for example, the class A has first preference, followed by the class B, and then the common. An additional fea­ture of most present-day preferreds is the cumu­lative provision, which means that if any divi­dends should be skipped, then such arrears must be paid up in their entirety before any payment may be made upon the common. Some compa­nies place a limit upon the extent of cumulation, often restricting it to the extent to which it has been earned.

As a rule, preferred stocks carry some rights as to their share in assets in time of liquidation, whether voluntary or involuntary. This is usu­ally limited to the stated par value, plus accrued dividends, plus sometimes an additional pen­alty. It is to be noted here, and also strongly em­phasized, that any preferred claims are always junior to those of bondholders in the event of liquidation. In some instances where a corpora­tion falls into financial difficulties, the sale of as­sets may leave little or nothing to satisfy the legal claims of the preferred stockholders after the bondholders have been paid off. From this point of view, it is obvious that the financial good health of any corporation is worthy of study.

Voting power is not conferred upon the pre­ferred stockholders in most cases, although there is usually a provision that when arrears are accu­mulated such stockholders may have the right to elect a certain number of directors in order to protect their interests. In some cases this regula­tion comes into effect if the arrears amount to four successive quarterly payments; in others it may be specified in years, since the management must be given some opportunity to rectify mat­ters. Still another kind of voting power given to preferred stockholders is that which permits them to vote as a class to block certain proposals which might endanger their rights and the rank of their stock. This veto power is most frequently applied to such matters as (a) proposed liquida­tion; (b) authorization of other preferred and/or bonded indebtedness; (c) proposed merger; (d) any change in the stated rights of the pre­ferred shares.

In recent years there has been a considerable increase in the popularity of convertible pre­ferred stocks, which bear with them a right to convert into the common stock of the issuing corporation at a stated rate; this rate may be on a share-for-share basis or may be a fraction, such as three quarters of a share of common for each share of preferred. Should the common be of in­creasing value throughout the years, it is evident that this conversion right may become very valu­able. If the reverse is true, then the privilege may become entirely worthless. In some cases conversion rights may be in effect for a consider­able length of time; in others there is a definite period during which they may be exercised and usually at a decreasing rate of conversion with the passage of time. At any rate, conversion rights must be protected against dilution through mergers, stock dividends, splits, etc., and such protection is usually provided in the articles. Some corporations achieve the same re­sult as conversion by attaching common-stock purchase warrants to the preferred shares; these may be detached and returned to the corpora­tion with the specified amount of cash required. As a rule such warrants are limited in time, but in a few cases they are specified as perpetual.

In many cases there is written into the articles of incorporation a regulation which obliges the purchase and retirement of a certain number of preferred shares annually. This is known as a "sinking fund" provision. The corporation sets aside from its earnings each year a certain amount, say $50,000, and it is required to re­deem preferred shares in that amount by exer­cising the right of call at a specified price. As a rule, the selection of such shares is made by lot. To the investor who may be anxious to preserve his investment in its entirety, this calling of shares for redemption may be annoying; but there is some compensation in the fact that the retirement of some shares reduces the number of shares outstanding and therefore tends to in­crease the assets behind those which remain; in addition, there will be some tendency to stabi­lize the price of those remaining, because the shares which are called for redemption are per­manently removed from the market.

Investment in preferred stocks may have a number of merits. Chief among them is a reason­able regularity of income coupled with a rea­sonable safety of principal, since the preferred stockholder is assured of certain rights with re­spect to the latter. The rate of return on pre­ferred stocks is often slightly higher than that which may be obtained on good-quality bonds. In addition, the high-grade preferred have al­ways shown considerable resistance to market fluctuations. It is to be noted that the better quality preferred stocks are now eagerly sought by insurance companies, trustees, endowment funds, and the like. We hasten to add, however, that all preferred stocks are not alike in quality, so that careful investigation should be made and investment confined only to upper-grade issues.

Those who argue against investment in pre­ferred stocks point out the following features: (a) there is limited return although consider­able risks of ownership are borne; (b) there is no enforceable right to dividends, since these must be declared by the board of directors and they may pass one or more dividends at their dis­cretion; (c) the owner of a preferred stock is in a position midway between that of a bondholder (creditor) and that of a common stockholder (partner), so that his stock is "neither fish nor fowl" and his position may eventually prove to be an uncomfortable one.

From the viewpoint of our typical investor of modest means we may say that there are a number of good-grade, low-par-value preferred stocks in which he may safely invest; among these are the stocks of certain very successful public utilities. The return, at least under pres­ent market conditions, is in the range between 4 and 5 per cent; these yields lie somewhere be­tween those of good-grade bonds and the better common stocks. Since all fixed charges have been covered over two and one-half times and since these utilities resist successfully the various ups and downs in the general business cycle, these preferred stocks represent good value and may well be included in the investment portfolio of the investor of modest means.

As is the case with all securities, we must em­phasize that there is no such thing as a "cheap" preferred stock, nor does the word "preferred" necessarily operate as some sort of magic wand. Those which are of poorer grade will reflect just that appraisal in their prices, sometimes fluctuat­ing within wide limits because of the varying fortunes of their respective companies. Perhaps the best rule to follow would be to insist on good quality; in this way there is at least some insur­ance of safety of principal, not to mention regu­larity of income.

It must be remembered that the chief risk in all high-grade securities (bonds and preferred stocks) is not related to the general course of business activity. It is most commonly related to the current rates of interest; in other words, whether money is plentiful or is "tight." This has already been mentioned in our discussion of bonds; it also applies to the market price and the yield of preferred stocks.

Should a choice be required between invest­ment in bonds and preferred stocks, there would seem to be a number of good reasons to prefer the former. Bond interest must be paid and is a first claim on earnings, but directors may pass a preferred dividend when earnings do not permit payment and force the preferred into arrears.

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