How to Invest Money

by George Garr Henry

RAILROAD MORTGAGE BONDS

A railroad bond is an obligation of a railroad company (usually secured by mortgage upon railroad property) which runs for a certain length of time at a certain rate of interest. It is apparent, from this definition, that the price of a railroad bond, as distinct from its value, is affected by two accidental conditions quite apart from the five determining qualities described in the preceding chapter.

These accidental conditions are the length of time that the bond has to run and the rate of interest that it bears. To understand clearly the influence of these accidental conditions is a matter of the utmost importance. It is evident, for instance, that a 5-per-cent fifty-year bond, based on a given security, will sell at a widely different price from a 3½-per-cent twenty-year bond, based on the same security; yet the only difference is in the accidental conditions which are under the control of the board of directors.

In order to eliminate these accidental features from the situation, it is customary for bond-dealers to classify bonds purely on the basis of their yield, or net income return. As a thorough understanding of this point is essential to an accurate judgment of bond values, whether railroad bonds or otherwise, it must be developed in detail, even at the risk of carrying the reader over familiar ground.

If a bond sells above par, it does not yield its purchaser a net return as great as the rate of interest which the bond bears, for two reasons: first, because the loss in principal, represented by the premium which the purchaser pays, must be distributed over the number of years which the bond has to run, and operates to reduce the rate of interest which the holder receives; and, secondly, because the rate is paid only on the par value of the bond instead of on the actual money invested. Thus, if a 6-percent bond with eight years to run sells at 110¾, it will yield only 4.40 per cent, which means that if the holder spends more than $48.73 (4.40 per cent of $1,107.50) out of the $60 which he receives annually, he is spending the excess out of principal, and not out of income. Conversely, if a bond sells below par, it yields more than the rate of interest which the bond bears.

These yields have been calculated with the utmost exactness for all bonds paying from 2 per cent to 7 per cent and running from six months to one hundred years, so that it is only necessary to turn to the tables to discover what will be the net return upon a given bond at a given price. This net return is generally known as the "basis," and bonds are spoken of as selling upon a 3.80 per cent basis or a 4.65 per cent basis or whatever the figure may be, with no reference whatever to the price or to the rate of interest which the bond bears. Indeed, so exclusively is the basis considered by bond-dealers that very often bonds are bought and sold upon a basis price, and the actual figures at which the bonds change hands are not determined until after the transaction is concluded.

It is not expected, of course, that the average business man will purchase bonds in quite as scientific a way as this, but it is essential that he should understand that while the intrinsic value of a bond is determined only by the five general factors described, its money value, or price, is affected also by these two accidental conditions. Exprest in other words, he must realize that the general factor described as rate of income does not mean the coupon rate of interest which the bond bears, but the scientific "basis," derived by elimination of the accidental features.

Within the past year there has been a good deal of uninformed comment about the safety of railroad bonds. Before the era of popular agitation and governmental antagonism, railroad bonds enjoyed a large measure of public confidence; but it can not be denied that some part of this confidence has been shaken as a result of the recent exposures. Even clearheaded men have exaggerated the importance of the developments; and too often railroad officials, who should have insisted upon the soundness and stability of their properties, when they elected to talk for publication, have given way instead to dismal and unwarranted forebodings.

There is no mystery involved in determining the safety of railroad bonds. Any man of business experience, keeping in mind the general principle which measures the value of all obligations, can easily determine, with the aid of two documents, the degree of safety which attaches to any particular railroad bond. The general principle to be observed is that the safety of any obligation depends upon the margin of security in excess of the amount of the loan; and the two documents to be consulted are the mortgage or trust indenture securing the bonds, which describes the property mortgaged, and the last annual report of the railroad, which shows its financial condition.

Confining the analysis, for the present, to mortgage bonds upon the general mileage of a railroad, the following points should be considered: