( Originally Published 1939 )
IF we find that the Compass Motor Company has an issue of bonds outstanding, let's first determine the character of the bonds. They can be divided into two classes, commonly known as mortgage bonds and debentures.
Care should be exercised in determining the indenture under which the mortgage bond was issued, for it may be in a series which constitutes a second mortgage, just the same as on a house and lot.
First mortgage bonds, as a rule, constitute a prior claim on the specific property pledged by the corporation, which is usually their entire property, and is a direct obligation of the company. This includes a pledge against their earnings, their properties, their subsidiaries, and their stocks and bonds. A second mortgage naturally follows in sequence, after the first mortgage has been satisfied.
Another type of security often confused with the bond, is known as the debenture. Unlike the first or second mortgage bonds, however, a debenture has no mortgage claim against the property. While it is a direct obligation of the company it is not secured by property.
The Compass Motor Company, finding itself in need of additional capital to finance the products which they have sold, issues a series of debentures. These debentures are generally secured by the cash assets and the outstanding accounts receivable, and are usually of short-term duration. In effect, the debenture holder is simply a preferred creditor, and in the event the debentures are not paid, he cannot foreclose as can the first mortgage bonds, but must resort to petitioning the courts to place the company in a receivership.
Having determined the two classes, bonds and debentures, the next step is to determine the strength of each. The best barometer to use in doing this would be the test of earnings, for while the first mortgage is secured by property and the debentures by earnings, nevertheless, they both depend on earnings for the payment of their interest and their ultimate amortization or retirement.
We will consider first, the first mortgage bonds. Say the Compass Motor Company has a net worth of $3,000,000 and that $1,000,000 of five percent first mortgage bonds, and $100,000 of seven percent debentures are outstanding. The equity behind each of these bonds is obviously $3,000 per bond, but, in considering this equity, bear in mind that you arrived at the net worth of $3,000,000 from the company's balance sheet, and you should determine to the best of your ability, the accuracy of the figures arrived at, and what relation they bear to liquidation in either prosperous or adverse times.
Due to the fact that the net worth might appear somewhat ambiguous to some investors, they often prefer using the barometer of earnings to determine the desirability of a bond. If the Compass Motor Company's earnings shows $500,000 per year, they have earned their bond interest requirement ten times over. This would leave $450,000 to meet any requirement they might need for the $100,000 seven percent debentures. In considering either bonds or debentures, first determine the equity behind the bond, and then the average earnings over a period of years. The ratio of earnings over a period of five years, measured, against interest charges, should reflect the stability of earnings as they may be required to meet interest charges.
Having decided that there is a sufficient equity behind the Compass Motor Company's 1945 bonds, and their average interest earnings justifies an investment, you are then interested in determining what provision they have made or are making to repay you your principal, or, in other words, the retirement of this bond on the date of maturity.
Different companies employ different methods. Sinking funds are provided with so much set aside each year to meet the ultimate date of maturity, and then again, some companies set aside a certain percentage of their net earnings. Mining and oil companies often set aside a specific amount on each ton of ore mined, or each barrel of oil produced, so as to insure the bondholder against depletion. The investor must necessarily use caution in determining what provisions has been made against the day of maturity, and care should be exercised in ascertaining the provision made by companies whose earnings depend on natural resources which are constantly being depleted.
If the Compass Motor Company decides to set aside a specific amount for the ultimate date of maturity each year, what happens to the funds which go to make up this sinking fund? If the company uses it from time to time, to go into the open market and purchase their bonds, it necessarily increases the equity of the remaining bonds; and as this bond liability decreases they become more and more attractive. In other words, if they retire $250,000 of their bonds, either by purchasing them in the open market, or take advantage of some clause which might permit them to call them at a certain time or premium, then the remaining bond indebtedness would be only $750,000. Thus the equity of each bond increases, and the average earning ratio over interest charges rises twenty-five percent.
The investor should also determine whether or not the bonds he purchases carries a redemption clause. Some bonds are redeem-able in whole, or in part, at the option of the company, subject to thirty, sixty or ninety days notice. If such a redemption clause appears, the investor can never be certain-as to just when his bond may be called. This might tend to work a hardship on those who are investing for long-term periods.
Another feature of bond purchase, which is vitally important to the investor, is the conversion privilege. The Compass Motor Company may have issued their bonds with the privilege of convetting them into common stock, up to a certain period of time. This is often done to make the bonds more attractive. For instance, the 1945's five percent may contain a clause permitting the owner to convert it into the common stock of the company, up to say, June 15th, 1941, at a certain ratio.
This ratio may be in terms of dollars or may be in terms of shares. For instance, a thousand dollar bond may be exchanged at the rate of $100.00 per share for the Compass Motor Company's common stock. On the other hand, the indenture may read that up to June 15th, 1941, the $1,000 bond can be converted into 10 shares of the company's stock. If the stock should be selling around $125.00 per share at anytime during that period, the bond holder quite naturally finds it to his advantage to exercise his conversion privilege, and thus take his $250.00 profit.
As a rule, however, the nearer the maturity date of the bond approaches, the higher the conversion privilege. That is to be expected, for as bonds are retired, or the sinking fund grows with which to retire the bonds, the capital structure decreases so to speak, and the stock becomes more attractive. As I said before, however, conversion privileges are usually issued to make the marketing of the bond easier and more attractive..
The investor who thus contemplates buying bonds, should first determine the type of bond, whether first mortgage or debenture, the equity behind the bond, the number of times the earnings cover the interest requirements, the type of sinking fund for payment or amortization, the redemption clauses, if any, and the conversion privileges.