Bonds - Terms Defined
( Originally Published 1918 )
While the interest on a $1,000 five per cent bond is always $50 a year, the actual percentage of yield or income to the investor is more than five per cent or less than five per cent according as the price paid for the bond is at a discount or a premium. Standard tables of figures have been prepared by mathematicians and actuaries for use in such transactions, which show what is earned on a given bond at a given price.
(Courtesy Halsey, Stuart & Co.)
Municipal Bonds are the obligations of cities, states, schools, districts, etc. and are issued for the purpose of financing local improvements. They are payable from taxes, and income derived from them is exempt from Federal Income Tax. A community may have outstanding several direct obligation bond issues, each for a different purpose, yet no one issue, because of its purpose, has priority over the remainder.
Where a bond issue is for improvements, such as roads, paving or similar improvements of limited life, it is advisable to have the bonds mature before the improvements for which they are issued become obsolete. In Illinois, no bonds can be issued for longer than twenty years and at the time of issuance provision must be made for payment at maturity.
First Mortgage Bonds. Bonds are ordinarily designated by the nature of their lien, as first mortgage, second mortgage, first and refunding mortgage, collateral trust, etc., or by the purpose for which they are issued; for instance, ex-tension bonds, improvement bonds, equipment bonds, etc. A first mortgage bond is a promise to pay to the holder a fixed amount in interest at stated intervals and the principal sum when due. As security there is pledged the properties and earnings of the company whose obligation they are and on which the bonds are a first lien.
First and Refunding Bonds. Similar to the above except that the bonds are a first mortgage on only a part of the properties, and a mortgage subject to prior liens on other parts. As the underlying issues mature, the first and refunding bonds replace them until they eventually become first mortgage bonds.
Collateral Trust Bonds and Notes are secured by the deposit with the trustee (generally some large and well-known trust company), of collateral in the form of other securities. When interest rates are high it is often advisable for a company to pledge its long term bonds as security for the issuance of short term notes and thus avoid the payment of a high interest rate for a long period of time. Again, the credit of a large company may be better than that of its subsidiaries and if these subsidiaries are in need of funds it is, therefore, advisable for the parent company to issue bonds under its own name with the securities of the subsidiary as collateral for the loan.
Gold Bonds or Notes are those which at maturity are payable, if the holder desires, in gold, "of the present weight and fineness."
Debentures. An unsecured promise to pay which, however, ranks ahead of the company's stocks. Debentures are frequenty further safe guarded by provisions in the indenture under which they are issued, requiring the maintenance of a fixed ratio of current assets in relation to the debenture issue, also limiting the creation of any new indebtedness which might take precedence over the debenture issue.
Coupon Bonds. Their interest is in coupon form, payable to bearer upon presentation when due. The principal sum, unless registered, is, in like manner, payable to bearer at maturity.
Registered Bonds.--If bonds are registered as to, principal only, the principal sum when due is payable only to the one in whose name the bond is registered. If fully registered, that is, as to both principal and interest, not only the principal, but the interest as well, is payable, when due, to the one in whose name the bond is registered.
Listed Bonds. Those issues, which, having complied with certain requirements, are listed on one or more of the Stock Exchanges of the country and may, therefore, be traded in on those Exchanges. The principal Exchanges are in New York, Chicago, Boston, Philadelphia, St. Louis, and San Francisco.
Interim Certificates. Sometimes called Temporary Bonds When the permanent or definitive bonds are not immediately available for delivery, the company will often issue its temporary certificates until the permanent bonds are ready, these being exchangeable for the definitive bonds when available, and drawing interest at the same rate as the permanent bond.
Underlying Bonds or Prior Lien Bonds are those which are a lien on properties prior to that of some other issue. For example, a first mortgage bond is an underlying bond as compared to a second mortgage bond on the same property.
Junior Securities. The opposite of underlying issues. In other words, their lien, rather than preceding, follows that of some other issues. Stocks, unsecured notes, second mortgage bonds, etc:, are securities junior to a company's First Mortgage Bonds. The value of the junior Securities is often an acceptable measure of the security behind the underlying issues, for the value which they represent would have to be destroyed entirely before the safety of the under-lying securities would be at all jeopardized. Naturally, the greater their value, the more security is afforded the underlying issues.
Capital Stock represents the ownership of the company. Each share of Preferred Stock and Common Stock into which the Capital Stock is usually divided, represents a part ownership of the assets of the company and comes after its bonds in security. The income of a stockholder is in the form of dividends. No dividends are available for the stock until all bond interest has been paid.
Funded Debt. The bonds, notes and other such indebtedness of a company comprise its funded indebtedness, the holders of which are creditors of the company.
Authorized issue. To provide for future growth a company will frequently authorize a larger bond issue than its immediate needs demand. This may take the form of either a limited or unlimited mortgage. In either case additional bonds can be issued only under care-fully drawn restrictions.
Closed Mortgage is one where no more bonds may be issued under that mortgage, the authorized amount having been fully issued. Any additional financing that the company may do on the same property must take the form of Junior Lien Securities.
Unlimited Mortgage is one where the amount of the issue is limited not to a definite sum, but by carefully drawn restrictions relating to earnings and cost of the improvement. These restrictions, if conservatively drawn, protect the bondholder as adequately as thought the amount of the issue were limited to a definite sum. They also relieve the issuing company of the trouble and expense of preparing frequent new mortgages as additional funds are needed. An unlimited mortgage also simplifies the financial plan of the company in as much as all of its financing may be done under one mortgage rather than having outstanding several issues brought out under different mortgages, a market having to be made for each new issue as it is issued.
Net Earnings. The earnings after the payment of taxes and operating expenses-in other words the amount available for the payment of bond interest.
Surplus Earnings. The amount available after the payment of fixed charges (bond interest, etc.). Such funds may, at the discretion of the management, be used for the payment of dividends to the stockholders, for the creation of a surplus, or for the improvements and extensions, etc.
Margin of Safety This is a percentage figure showing the proportion of net earnings remaining after the payment of all fixed charges. For example, if the net earnings are $500,000, and the fixed charges $200,000, the margin of safety is $300,000, or 60%.
Equity is the difference between the bonded indebtedness of the company and a fair valuation of its properties. For example, a company whose properties are conservatively valued at $2,500,000, and having a bonded debt of $2,000,-000, would show an equity of $500,000.
Franchise. Most Public Service Corporations operating in part on public thoroughfares and' supplying a public necessity, as in the case of street care companies, gas, electric and water companies, must obtain permission from the community to operate. This is generally granted for a period of years and is known as a Franchise.
Trustee. The mortgage under which Corporation Bonds are issued is ordinarily called a Trust Deed and is made out to a trustee, generally a large trust company, which holds the title to the properties during the life of the bonds as security for bondholders, and whose duty it is to see that the terms of the mortgage are complied with. All bonds must be certified by the trustee, that is, signed by an officer of the trust company, to be valid.
Trust Deed, Deed of Trust, Mortgage or In-denture, as the term is used more or less inter-changeably, is the legal document defining the terms of issuance and payment of the bond issue. It states the nature of the lien of the bonds, and places the title to the mortgaged properties in the hands of a trustee, for the security of the bondholders during the life of the bond issue. It also states the provisions for maintaining the security of the bonds and the restrictions under which additional bonds, if any, may be issued.
Escrow Bonds. That part of the authorized issue which remains unissued with the trustee until additional financing is to be done; these bonds may be released only when the mortgage provisions governing the issuance of additional bonds are complied with.
Sinking Fund. A fund, usually maintained by periodic payments of a stated percentage of earnings, production or of outstanding bonds, the purpose of which is the ultimate redemption of the company's bonds, either by payment at maturity, or by purchase before maturity, to be held until maturity or for immdeiate retirement.
Optional Payment Date. In the case of a long term bond there is a possibility that before maturity it may be desirable to readjust the company's financial plan because of lower interest rates, consolidation of the debt, or other good reasons, and to this end a majority of corporations reserve the right to call their bonds for payment before maturity, but only upon a reasonable notice and frequently at a premium.
"Approved by Public Service Commission." The growth and importance of public service corporations has induced in many states the creation of a regulating body known as a Public Service Commission. It is the duty of such a commission to supervise the operation of companies coming under its jurisdiction, also to pass upon the issuance of their securities. To the companies, the laws creating these commissions insure freedom from competition, and in some states unlimited franchises so long as satisfactory service is rendered at reasonable prices.
Collateral Security. Collateral is something of a known value left by the borrower as a pledge for payment of a loan; for example, a man borrows $700.00 from a bank and leaves a $1,000.00 bond with the bank until he has paid back the loan, when his $1,000.00 bond is returned to him. Should he default in paying back the $700.00 the bank has the right to sell his collateral, which in this case is $1,000.00 bond, and apply it to his debt and pay him the surplus or over plus.