(6) _Fixt charges per mile._ The fixt charges of a railroad include interest on its bonds, rentals, and taxes (when the last-named are not reported with operating expenses). The importance of this figure lies in its relation to net income. If a railroad does not earn well over double its fixt charges, its obligations can not be regarded as in the first investment rank. Of course, when a railroad earns more than twice the interest requirement upon its entire bonded debt, it is probable that some of the underlying bonds are protected by three, four, or five times the interest requirement upon them, and their position is correspondingly strengthened.
The foregoing analysis applies particularly to mortgage bonds upon the general mileage of a railroad and not to such special issues as collateral trust, terminal, bridge, or guaranteed bonds. It will not be necessary, however, to lay down any rules as to these classes of bonds, for the general principles outlined above, with slight modifications of detail, will be found equally applicable to a judgment of their value. Equipment bonds, on the other hand, owing to their want of similarity to any other railroad issues, will receive separate treatment later.
It is of interest, in view of the present diminished confidence in railroad securities, to advance certain considerations touching upon the safety of railroad bonds in general.
The last published report of the Inter-State Commerce Commission, year 1906, furnishes interesting testimony on this subject. A table on page 60 shows that the total railroad capital of the United States for that year was $14,570,421,478, of which $7,766,661,385, or 53.31 per cent, was in the form of bonded debt, and the rest in capital stock.
These figures indicate a substantial equity, but are somewhat misleading because they refer to par value. A fair estimate of the market value of this stock equity, which is the margin of security in the properties from the bondholder's point of view, can be obtained from a table on page 82, which shows a balance available for dividends, after paying all operating expenses and fixt charges, of all the railroads of the United States for the year ended June 30, 1906, of $457,060,326. This amount is equivalent to nearly 7 per cent upon the total par value of the stocks.
Estimating that a railroad stock should earn 10 per cent upon its market price--and even the most prejudiced will admit that a stock earning 10 per cent is worth par--the total market value of American railroad stocks would be $4,570,603,260, or more than half the par value of the bonds. In other words, the bonded debt would represent something less than 63 per cent of the total market value of the property. This compares favorably with the security of first mortgages upon real estate.
When the safety of interest is considered, the showing made is equally strong. Page 82 of the report above quoted shows that the net income of the railroads of the United States for the year ended June 30, 1906, after payment of all operating expenses, was $848,836,771, and the total fixt charges, including interest on bonds, interest on current liabilities, and taxes, amounted to $391,776,445, leaving a balance available for dividends of $457,060,326. It is apparent, therefore, that the net earnings of the railroads of the United States, considered as one system, could be cut in half without affecting the payment of interest upon the railroad's obligations. This affords a large measure of protection.
The following analysis shows that the actual market value of the railroads is probably greater than the estimate made above.
The table shows the percentage of bonded debt to total market value of some of the more important railroad systems. Two trunk lines in the East, a north and south line in the middle West, and two transcontinental have been chosen. No attempt has been made to select railroads which would make a favorable showing. Indeed Pennsylvania, and Union Pacific, by reason of their recent heavy bond issues, probably compare unfavorably with others which might have been chosen. The figures showing the par value of bonds outstanding have been taken from last annual reports, with additions made for recent issues. The figures showing the market value of stocks are based on the amounts outstanding April 1st, 1908, at the market price.
Par value of Approx. market Per cent bonds outstanding value of stock of bonds outstanding to total value
Pennsylvania $270,974,645 $361,000,000 42.8 New York Central 255,414,845 174,000,000 59.4 Illinois Central 156,053,275 120,000,000 56.6 Great Northern 207,517,939 260,000,000 44.3 Union Pacific 274,827,000 324,000,000 45.9
In view of the enormous decline which has occurred in railroad stocks during the past eighteen months, the showing above is truly remarkable. It is plain that the entire bonded debt of any of these standard railroads is less than 60 per cent of the total market value of the property, while in the cases of the Pennsylvania, Great Northern, and Union Pacific, _more than half of the present market value of the property could be erased before the lien of the bonds least well secured would be impaired_.
Of course, where the entire bonded debt is protected by such a margin, it is evident that the underlying bonds (the prior liens and first mortgages) are protected by several times as great a margin and their position is correspondingly strengthened.
The foregoing analysis, in the judgment of the writer, affords convincing proof not only that the prevailing want of confidence in railroad obligations is without foundation, but that railroad bonds compare favorably in point of safety with any other form of investment.
It remains to point out the amount of income and degree of convertibility which they afford and the extent of appreciation in value which they promise. It is impossible to do more than indicate the general characteristics of railroad bonds in these particulars.
Railroad bonds cover a wide range of income return. They yield all the way from 3-3/4 per cent to 9 per cent, the general average being from 4 per cent to 6 per cent. As a class they yield more than government or municipal bonds, and less than public-utility or industrial bonds. With equal security they probably yield less than real-estate mortgages. Compared with stocks they return more than bank stocks, average about the same as railroad stocks, and yield less than public-utility, industrial, or mining stocks. These comparisons are intended to apply to the classes as a whole, and remain generally true in spite of specific cases to the contrary.
Convertibility is the distinguishing mark of railroad bonds. Generally speaking they may be more easily marketed than any other class of bonds. Compared with stocks they exceed public-utility, mining, and bank stocks in point of convertibility, and yield only to railroad stocks. It is hard to say whether or not they possess greater convertibility than industrial stocks, but it is probable that they do, allowing for the fact that an undue impression is created by the activity of certain prominent shares.
Railroad bonds as a class possess great promise of appreciation in value. American railroads, generally speaking, have adopted the conservative policy of putting a considerable part of their annual earnings back into the property in the form of improvements. To the extent to which this policy is followed, an equity is created back of the bonds which raises their intrinsic value. This policy contrasts favorably with the general practise of English roads to pay out all their earnings in dividends, and to capitalize their improvements. In addition, new capital for American railroads is largely raised by stock issues, which further increases the margin of security for the bondholders. Taken together these facts insure a steady enhancement in the intrinsic value of railroad bonds, which is bound to be reflected, other things being equal, in higher prices.
We shall not attempt to discuss at this time the degree of stability of market price which railroad bonds enjoy. As explained in the first chapter, stability of market price is dependent upon general financial and business conditions. It is sufficient to point out here that the maintenance intact of the principal sum invested can only be rendered certain by the purchase of short-time securities whose near approach to maturity will keep their price close to par. In a later chapter the general principles which determine this question will be elucidated.
The ideal investment may be defined as one combining ample security of principal and interest, a good rate of income, ready convertibility into cash, and reasonable promise of appreciation in value. Measured by the requirements of this definition, the conclusion seems justified that well-selected railroad bonds, if purchased under favorable money-market conditions, afford a highly desirable form of investment.
III
RAILROAD EQUIPMENT BONDS
As its name implies, an equipment bond is one issued by a railroad to provide funds with which to pay for new rolling stock--cars and locomotives. The issues are variously described as car trust certificates, equipment bonds, or equipment notes. They conform in general to one of two standard forms: (1) The conditional sale plan: In accordance with specifications furnished by the railroad, the trustee selected (usually a trust company) contracts with the builders for the purchase of the equipment. From 10 to 20 per cent of the cost of the equipment is paid in cash by the railroad and the rest is represented by the equipment bonds. The bonds are the direct obligation of the railroad company. They are secured by a first lien upon the entire equipment purchased. The title to the equipment remains in the trustee for the benefit of the bondholders until the last bond has been paid, so that under no circumstances can the general mortgages of the railroad attach as a first lien on the equipment ahead of the car trust obligations. After the final payment, the trustee assigns title to the railroad company, which thereupon becomes the owner in fee of the equipment. Under the terms of the deed of trust the railroad is always obliged to keep the equipment fully insured, in good order and complete repair, and to replace any equipment which may become worn out, lost, or destroyed. The bonds are usually issued in coupon form, $1,000 each, bearing semiannual interest, with provision for registration. They are generally paid off in semiannual or annual instalments of substantially equal amounts, the last instalment usually falling due in ten years, a period well within the life of the equipment as estimated under the master car builder's rules. Occasionally this method of payment is altered by the substitution of a sinking fund, the bonds having a uniform fixt maturity, but subject to the operation of a sinking fund which is sufficient to retire the entire issue well within the life of the equipment. In either case the security, ample at the outset, increases proportionally with the reduction in obligations outstanding against it.
(2) The so-called "Philadelphia plan." Under this plan the equipment is purchased by an individual, association, or corporation which leases the equipment to the railroad for a term of years at a rental equivalent to the interest and maturing instalments of the bonds. The contract of lease is then assigned to a trust company as trustee, which thereupon issues its certificates in substantially the form described in the plan above, these representing a beneficial interest in the equipment, which are usually guaranteed both principal and interest by the railroad. The lease runs until the last bond has been paid, after which the trustee assigns title to the railroad as above. The chief advantage of this plan over the other is that in some States, notably Pennsylvania, certificates issued in accordance with its terms are exempt from taxation, whereas under the conditional sale plan, as the direct obligation of the railroad, the bonds would be taxable.
It is evident from the foregoing description that equipment bonds differ in two important respects from all other classes of railroad issues. First, the title to the property which secures the bonds does not vest in the railroad; and, secondly, the property is movable and not fixt in any one locality.
By virtue of these two points, the holders of equipment bonds possess a great advantage over the holders of mortgage bonds in the event of a railroad's becoming bankrupt.
If a railroad is unable to meet its interest charges, the mortgage bondholders can rarely do better than have a receiver appointed who will operate the railroad in their interest; but if, with honest and efficient management, the railroad can not be made to earn its interest charges, the mortgage bondholders usually have to consent to the scaling of their bonds to a point where the railroad can operate upon a paying basis.
With the holders of equipment bonds the case is quite different. If the receiver defaults upon their bonds they have only to direct the trustee to enter upon possession of the equipment and sell it or lease it to some other railroad. The knowledge that they possess this power renders its exercise generally unnecessary. The equipment of a railroad is essential to its operation. It is the tool with which the railroad handles its business. If the receiver were deprived of the equipment it would be impossible for him to operate the road, and so he could never satisfy its creditors. Consequently the courts, both State and Federal, have ruled that the necessary equipment of a bankrupt railroad must be preserved, and have placed the charges for principal and interest of equipment obligations upon an equality with charges for wages, materials, and other operating expenses, and in priority to interest of even first-mortgage bonds.
These points sufficiently explain the remarkable record which equipment bonds have made during reorganizations. Careful investigation has been made of the various railroads which were reorganized, either with or without foreclosure, between the years 1888 and 1905. This covers the chief period of railroad receivership. It was discovered that sixteen different railroads, aggregating nearly one hundred thousand miles and located in widely different parts of the country, had outstanding equipment bonds at the time of default. In every case the principal and interest of equipment bonds were paid in full, while all other securities, with a few exceptions, were reduced in rate or amount or both. Two of these railroads offered to the holders of equipment bonds the option of an advantageous exchange of securities, which amounted to more than payment in full.
The foregoing facts justify the conclusion that equipment bonds possess security equal or superior to that of any other form of railroad bonds.
Let us now consider their remaining characteristics--their rate of income, convertibility, prospect of appreciation in value, and stability of market price.
One of the strongest features of equipment bonds is the relatively high rate of income which they yield. The amount realized varies in accordance with the financial strength and credit of the issuing railroad, and the margin of security in the equipment itself. As a general rule, the net return on the equipment bonds of a given railroad is usually from 1/2 per cent to 3/4 per cent greater than on the first-mortgage bonds of the same railroad. This is owing to the fact that while banks and scientific investors have bought equipment bonds for many years, the general public is not sufficiently familiar with the inherent strength of these issues to create much of a demand for them. This insures a good return.
Equipment bonds vary in point of convertibility. The reader will remember from the description above that equipment bonds are usually issued in serial form, with instalments maturing semiannually from six months to ten years. By confining purchases to the shorter maturities, say within two or three years, a high degree of convertibility may usually be obtained because the short maturities are greatly sought by banks and other financial institutions which regard equipment bonds in much the same light as merchant's paper or time loans secured by collateral. At a price equivalent to the rate which the best commercial paper commands, there is always a good demand from the banks. Many banks prefer equipment bonds to loans or paper on account of their greater convertibility. As the length of maturity increases, the degree of convertibility generally decreases, because the chief demand for the longer dates comes from insurance companies, which do not, in the aggregate, constitute as great a demand as the banks. When the demand from private investors increases, as it undoubtedly will when they become more familiar with the desirable points of these issues, all maturities will probably possess ready convertibility.
In the same way, equipment bonds vary as to stability of market price. Compared with other classes of railroad issues, equipment bonds are all relatively stable, but the stability is especially marked in the shorter maturities.
Equipment bonds possess little prospect of appreciation in value.
The attentive reader who has carefully followed the foregoing description of equipment bonds, may have noticed a special adaptability on their part to the requirements of a business surplus. Broadly speaking, for such investment, a security is required which will combine perfect safety of principal and interest, a good rate of income, ready convertibility into cash, and unyielding stability of market price. The necessity for insistence upon these requirements in the investment of a business surplus will appear upon a moment's reflection. Safety is required in all forms of investment, but is particularly important in the handling of business funds; a good rate of income is always desirable; convertibility is necessary for a business surplus so that the reserve funds may be converted into cash at any time; and it is of the utmost importance that the security should not shrink materially in quoted price, no matter what changes may take place in financial and business conditions, so that if the need should arise for realizing on the reserve fund, it would be found unimpaired in amount. As explained in a former chapter, this point can not be covered by the selection of securities perfectly safe as to principal and interest, but only by the purchase of short-term obligations.
The point may be illustrated as follows: Let it be supposed that a firm or company has decided to invest $100,000 in the 5-per-cent equipment bonds of a good railroad maturing in three years, which can be obtained at par, merchant's paper then commanding about 5-1/2 per cent. After two years it becomes necessary for the firm to realize on its investment at a time when commercial paper is floated with difficulty on a 6-1/2-per-cent or 7-per-cent basis. Under such money conditions the equipment bonds could be sold on about a 6-per-cent basis, which would mean a price of 99 for a 5-per-cent bond with one year to run. The firm, in liquidating its investment, would therefore lose 1 per cent in principal, but would have received 5 per cent interest for two years, making the net return 4-1/2 per cent. Compare this showing with the result if the bonds when originally bought had had ten years to run instead of three.
After two years, when the firm wished to dispose of its bonds it might experience some difficulty in doing so in the stringent money market which has been supposed, but even if it succeeded in selling them upon a 6-per-cent basis, that would mean a price of only 93-3/4 and would represent 6-1/4-per-cent loss in principal. If it were necessary to sell the bonds upon a higher basis or if the firm had purchased a bond with more than ten years to run, the relative disadvantage of the longer bond would be still more apparent. These points sufficiently demonstrate the importance of buying only short-term securities for the investment of a business surplus. Of course, if money conditions improve instead of becoming worse between the dates of purchase and sale, then a greater profit would be made with the longer-term bond. This, however, should not be allowed to influence the choice, first because it is not the object of a reserve fund to make a speculative profit, and secondly because a firm or corporation is only likely to want to realize upon its reserve fund when money is hard to obtain otherwise, and that is precisely the time when any long-term bond would be apt to show considerable depreciation.
The foregoing considerations indicate a special adaptability on the part of equipment bonds to the usual requirements of a business surplus. The points have been brought out at some length because of the importance of the subject to the average business man. The purpose in concentrating attention upon a single instance has been to illustrate more clearly the principles involved and at the same time to acquaint the business man with details of a highly desirable and somewhat unfamiliar form of security.
IV
REAL-ESTATE MORTGAGES
In the preceding chapter the discussion of railroad bonds was brought to a close. Before passing to the consideration of real-estate mortgages, which is the next form of investment to be taken up, it may be well to review briefly the general principles advanced in the first chapter of this book, in order that the reader may have clearly in mind the main points upon which judgment of the value of investments should be based.
There are five chief points to be considered in the selection of all forms of investment. These are: (1) safety of principal and interest; (2) rate of income; (3) convertibility into cash; (4) prospect of appreciation in intrinsic value; (5) stability of market price.
Keeping these five general factors in mind, the present chapter will discuss real-estate mortgages as a form of investment, both as adapted to the requirements of private funds and of a business surplus.
The average American business man is so familiar with real-estate mortgages that the details may be passed over briefly. A real-estate mortgage, or a bond and mortgage, as it is sometimes called, consists essentially of two parts, a bond or promise to pay a certain sum of money at a future date with interest at a certain rate per annum, and a mortgage or trust deed transferring title and ownership in a piece of real estate, with the provision that the transfer shall be void if the interest is regularly paid and the bond redeemed at maturity. Before advancing money on the security of a mortgage it is necessary to determine whether the title to the property legally vests in the maker of the mortgage; and during the continuance of the mortgage it is necessary to have proof that the taxes and assessments are being regularly paid, and, in the case of improved property, the fire-insurance as well.
The safety of real-estate mortgages, in common with the safety of all obligations, depends upon the margin of security in excess of the amount of the loan. In the case of real-estate mortgages the amount of this margin may be determined without great difficulty. It is only necessary to have the property carefully appraised by an expert in real-estate values. It does not follow, however, because a mortgage has been shown to possess substantial equity, that it is perfectly safe as an investment, unless it satisfies also another condition of great importance. A mortgage may not exceed 50 per cent of the selling value of the real estate pledged, and yet be a poor investment. This point involves a serious objection to real-estate mortgages which sometimes escapes notice.
The holder of a mortgage is at a great disadvantage in regard to the changing value of real estate. If the value of the property upon which he holds a mortgage increases, the additional value enhances the security of the loan, but does not add to the principal which he has invested, while if the value of the property diminishes, not only is the security proportionately lessened, but if the impairment be great, the holder is frequently compelled to take over the property and may suffer loss of principal. In other words, he receives no direct benefit from an increase in the value of the property, but has to stand the larger part of the risk of a decline in its value.
This is not the case with investments represented by negotiable securities subject to changing market quotations. All such securities, railroad bonds for example, are acted on equally by changes in the value of the property which secures them. Except for the influences of money-market conditions, railroad bonds advance with an increase in the value of the property and decline with a decrease in its value. Well-selected bonds usually increase in value with time, and all such increase goes directly to the benefit of the holder. The failure of real-estate mortgages to respond similarly to changes in the value of property places the holder of a mortgage at a great disadvantage.
Owing to this characteristic, real-estate mortgages should be purchased only when general conditions in the real-estate market are distinctly favorable. Not only should the purchaser of a mortgage have sufficient margin of security in the particular piece of property upon which he is loaning money, but he should also be satisfied that general real-estate values are relatively low, that there has been no undue speculation, and that conditions favor an advance rather than a decline in real-estate prices.
No class of property is subject to more rapid changes in value than real estate. After an extensive advance the holder of a mortgage may be insufficiently protected by the equity in the property, even if his mortgage represents only 60 per cent of the current appraised value of the real estate pledged. It may be that the 60 per cent which he has loaned represents the total value or more than the total value a few years before. When a rapid advance in values occurs, tho it may be largely justified by the growth and development of the territory, there is sure to be present an element of speculation which is likely to carry prices beyond the point of reason. When the turn comes and a severe collapse takes place, its effects are extremely disastrous, because, unlike speculation in stocks or commodities, no short selling exists in real estate to temper the fall, and the immobile form of capital makes liquidation impossible. These considerations serve to show the need for great prudence in the purchase of real-estate mortgages. If the investor exercises due care in these particulars, he is reasonably sure of obtaining a very high-grade security; if he neglects these precautions, he may suffer severe loss of principal.
No general figures are available which would indicate the degree of certainty attaching to the payment of interest upon real-estate mortgages. Certain classes of mortgages, such as those secured by unimproved real estate or dwellings, afford no direct security of interest payment other than the threat of foreclosure. Other classes, such as mortgages upon stores, hotels, or office-buildings, are often protected by a large income from the direct operation of the mortgaged premises, thus furnishing a security for the annual interest payment. The margin of protection in these cases varies greatly, so that no general conclusion can be drawn.
The other characteristics of real-estate mortgages may be passed over more briefly. It is generally conceded that mortgages return a higher rate of income than can be obtained upon any other form of investment which affords equal security. This constitutes their chief advantage.
Their chief disadvantage, on the other hand, lies in their entire want of convertibility. There is no market for real-estate mortgages, and except in special instances they can not be readily sold. The fact that they are not subject to quotation prevents them also from holding out any prospect of appreciation in value. Their very deficiency in this respect, however, constitutes an important advantage from another point of view. Since they are not quoted they can not shrink in market price in obedience to changes in financial and business conditions. The buyer of a mortgage is assured that he can carry his mortgage at par through periods when it may be necessary to mark down all negotiable securities subject to changing market quotations. This is frequently a matter of great importance.
The general characteristics of real-estate mortgages may be summarized as follows: (1) When carefully selected and purchased under favorable conditions, great safety of principal and interest; (2) a relatively high return; (3) a low degree of convertibility; (4) no prospect of appreciation in value; and (5) the practical certainty of maintaining the integrity of the principal invested.
Is a security possessing these characteristics a suitable investment for a business surplus? Only to a limited extent. The safety, high return, and assurance against loss in quoted value of principal are all highly desirable qualities for this purpose, but the lack of convertibility is a fatal defect. No consideration is of greater importance in the investment of a business surplus than a high degree of convertibility, so that if the need should arise the investment may be instantly liquidated. The fact that real-estate mortgages can not be readily disposed of makes it practically impossible to employ them for the investment of a business surplus.
Where convertibility is not an essential requirement, and where the want of promise of appreciation in value is not a serious matter, mortgages afford a very desirable form of investment. The characteristics which they possess in an eminent degree--safety, high return, and assurance against loss in quoted value of principal--are exactly suited to the ordinary requirements of savings-banks. Generally speaking, only a small proportion of a savings-bank's assets need be kept in liquid form or readily convertible, and accordingly they find mortgages highly desirable.
For the purpose of private investment the attractiveness of mortgages is not so easy to determine. Ordinarily, fluctations in quoted values are of no great importance to the private investor, so that the absence of quotation which mortgages enjoy is not especially valuable. Their safety and high return are attractive qualities, but their want of convertibility and of prospect of appreciation in value are drawbacks. On the whole, the private investor may probably employ with advantage a certain part, but not too much of his estate in mortgage investments.