The Financial Situation

Novelties which Have Been Adopted to Make Bonds Alluring

MERRYLE STANLEY RUKEYSER

DURING dustry, periods the Bondholder of recession gets in his inopportunity to laugh. After a period of gilded prosperity, which has meant lean years for him, he thrives— when business sags and activity slackens.

The bondholder, in a sense, resembles the sardonic soul who can smile at a funeral. Out of the ashes that follow the flame of great intensity in business, he gets solace and his reward.

And now, as the period of unrestrained spending is fading, the bondholder, who has suffered in the days of plenty, seems ready to come into his own.

Since 1914, the sliding of bonds down the chutes of depression has been especially rapid, but securities of this character have been suffering, off and on, ever since 1900. The turn seems near. Some very capable observers think it has already come.

Those investment bankers who are undertaking the dangerous task of foretelling the future are now remarking that the bond buying time has come, They predict that any one who purchases sound bonds now, to hold for a period of years, will make a profit, Only a few weeks ago, bonds of the highest grade were selling at the lowest ebb in generations.

As bonds tumbled to new valleys of declines, several discerning experts took the view that they were scraping bottom. But now the best opinion seems to be that good bonds are selling much cheaper than they will be offered five years hence. A catastrophe or a financial panic or a series of lesser setbacks might further depress bond quotations, but bankers who are America's financial leaders feel that the movement of gradual decline has about spent itself. Lower prices for bread, and overcoats, and musical instruments, mean higher prices for bonds. And that is why bloated bondholders who, figuratively, became emaciated in recent years will celebrate when other folk may be blue over the business outlook. Like the consuming public, the bondholder benefits from falling commodity prices, A $100 bond, paying $4 a year in interest, is worth more when the $4 will buy four bushels of wheat than in times of high prices when it will only purchase two bushels.

Common stock, which represents a share of the profits of commerce,—on the other hand—reaches the peak of market value when business activity is greatest. But not so with bonds, which constitute a loan. When trade throbs almost to the breaking point with activity, the demand for money usually climbs. This condition normally boosts the rental charge on money—the interest rate. And as the interest rate soars, the market value of old bonds, which bear a rate of interest lower than the current rate, falls to a point that will bring the return on them (to the new what purchaser he could in the get open by market) making up fresh to loans at current rates, or—what amounts to the same thing—purchasing newly created securities,

IN the last score of years, the prices of things have been ascending, as every one who has ever made a purchase knows, and the market value of bonds has been simultaneously declining, as every one with a bond in his strong box is aware. In the period of inflation during and after the war, the soaring of prices and the decline of bond values have been unusually rapid. But now the country is trying to buck the financial currents set loose by the war. The United States is struggling to counteract the ill effects of an ever rising cost of living (and what is technically known as inflation) by the application of a remedy which economists call deflation, which simply means squeezing the water out of the currency and credit systems with the primary objects of checking price spurts. There is evidence that the deflation movement in this country is under way. It may be sporadic and seasonal, but the trend seems to be away from ill advised overexpansion.

When commodity prices are lower, business should be able to finance itself with smaller borrowings. This condition should relieve the terrific strain on the money markets of the world, and bring about shrinking interest rates. If this turnabout comes, bonds of high merit, which fluctuate with changes in interest rates, ought to adjust themselves to the new situation by rising in market price. This logic applies to bonds of unquestionable worth. Speculative bonds of corporations or governments whose ability to discharge their debts at maturity is uncertain will also fluctuate with the changing fortunes of the institutions whose debt they represent.

In times of stress in the industrial world, when values crash and market quotations of stocks melt away with tragic rapidity, folk become timid in respect to their investments and are inclined to turn from the more speculative bonds to the more safe and sound bonds. That is another reason why bonds usually profit after a storm. In times of tremendous industrial prosperity, security buyers are usually too preoccupied seeking colossal fortunes in stocks to turn to the more prosaic, less dramatic market in bonds,

AND yet those investment bankers who are convinced that bonds are now going to do better do not necessarily foresee calamity in the business world. Their forecast can be realized merely as a result of an orderly readjustment of industry under the stimulus of the campaign of deflation inaugurated by the Federal Reserve Board of Washington.

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But, although the ultimate effects of deflation will be helpful to outstanding bonds, the first effects of deflation are to make the lot of the borrower (and hence the holder of outstanding bonds) harder. Deflation lessens the supply of money and credit at a time when it is in greatest demand. In the long run it is expected to cause industrial changes which will decrease the hunger for money of borrowers, but in the early stages it contracts the supply when it is already too small.

At present, we are in the early phases of the deflation movement, and consequently great ingenuity is required on the part of borrowers to woo dollars from potential lenders. For nearly a year, the degree to which the demand for money outstripped the supply has been acute, and as a result new fashions in finance have been created to induce folk to throw their savings into a common pot for industry by buying bonds.

Time was when a bond was simply a promise of a corporation or government to repay a given amount of principal at a certain day and to pay a specified rate of interest twice a year up to the time of maturity. That was when severe plainness of style prevailed in the bond market. But since the competition to get funds has become unprecedentedly intense new specialties and novelties have been added to bonds of the current season to make them doubly alluring to the public.

THE irregularities of the foreign exchange market have offered opportunities for giving special inducements to purchasers of foreign bonds. In the $250,000,000 United Kingdom loan floated here last Fall, an attempt was made to sell a conventional bond PLUS. This security was offered to yield from 6 to 6 1/4 per cent, and besides this return, which would normally be all the bondholder gets, the privilege of making a profit out of a possible movement of the pound sterling up toward normal in the exchange market, through the purchase of British National War bonds at a fixed rate. In the $25,000,000 Belgian loan, placed at the beginning of the year, was invented an even more direct device for giving the purchaser a chance to make a profit out of fluctuations in the exchange mart. Besides getting one or five year notes to yield 7 per cent per annum, the buyer received the privilege of obtaining at any time a fixed number of francs for his bond and making one half of any profit that might accrue from a betterment of the position of the Belgian franc in the international exchange market.

Both these obligations carry novel features which add to their worth, but the innovations are complicated and require a knowledge of the intricate exchange market, about which the notions of the average man are hazy. And because the buyer of relatively moderate means is now a commanding figure in the investment market, bankers in subsequent bond creations abandoned the exchange privilege for simpler attractions. In the more recent $50,000,000 loan to Belgium, for example, provision was made to redeem all the bonds at 115 between one and twenty-five years, according to drawings. The bonds bear on their face 7 *4 per cent interest, but will yield between 24.89 per cent and 7.95 per cent, depending on when the law of chance calls a particular piece for redemption. In this operation, instead of giving the bond buyer a speculation in exchange, the Belgian government assumed the risk itself. It was willing to bet that the Belgian franc will be nearer normal at the time of maturity than at the time of negotiating the loan. In June, when Belgium had a $50,000,000 maturity here to meet, thirteen francs were needed to buy a dollar, compared with 5.18U normally. The new loan deferred the day of settlement for Belgium, and, if the expected favourable developments in the exchange market come, the little country will be able to pay off the new obligation with much fewer francs and hence with this prospect is able to offer unusual attractions to American investors at this time. Despite the high interest rate .paid, the operation, provided the franc rises in terms of the dollar, may cost Belgium as little as 2 per cent.

In the recent Swiss loan of $25,000,000, provision is made to retire the bonds through a sinking fund at a premium of 5 per cent, but in this issue the main reliance was placed upon the high rate. Switzerland, which theretofore never paid more than 6 per cent for accommodations, in this instance offered 8 per cent.

THE small investor has a passion for high coupon rates. He would much rather buy an 8 per cent bond at par than a 6 per cent bond at a sufficient discount to yield 8 per cent. In his respect for the magic of par, the small buyer differs from the inordinately wealthy purchaser (who, on account of the su~ei taxes, buys many tax exempt securities now) and from the expert bond buyers af the great life insurance companies and savings banks.

In judging in advance his market for new securities, the investment banker must now make allowance for the taste of the small buyer. The other day the head of one of the principal houses of issue was asked to float a bond issue for a large industrial concern. Ordinarily he would have underwritten the loan without hesitation, as the credit of the borrower was of the highest. In the old days, when only 400,000 persons held bonds and distributing Consisted merely in approaching persons of accumulated wealth and the institutions, it would have been a simple matter for the banker to have resold such bonds, for these expert purchasers understood the credit of the borrower which was little known to the wider public. For the products it makes, though essential, are used in the intermediary steps of the process of manufacture and do not reach the ultimate consumer directly. Because this manufacturing house was so far removed from the public the banker hesitated to make the loan, for he questioned the salability of the bonds in the revolutionized market, which is completely dominated now by the man of moderate means. The banker finally compromised by granting the loan, but making the amount smaller than sought.

Not only the small buyer, but the large buyer, too, appreciates the novelties in recent issues. Special attractions have not been confined to foreign issues. Domestic corporations, in the fierce competition for funds, have also put extra window dressing on their offerings. For example, the newly issued $60,000,000 of Armour & Company notes, besides yielding 7¾ per cent interest for ten years, give the owners the right to convert them into Class A common stock. Thus, in addition to interest, note holders can share in any enhancement in the value of the stock that may take place during the next decade.

In the bond market, ten year obligations have been exceedingly fashionable this year. Borrowers, in view of the exceptionally high interest rates prevailing, have sought not to entangle themselves in longer obligations, because they feel that in future years it will be feasible to borrow money more cheaply. Creators of bonds are now of the opinion, however, that the investing public is fed up on short term obligations and wants longer bonds. It is to the advantage of the purchaser of fixed maturity obligations to get relatively long time obligations under the present conditions, which are so favorable to the lender.

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At this moment of flux in the world's history, when even the character of such constant things as bonds varies, it behooves the investor to apply new standards of safety. Beside the routine tests that are applied to a security, the buyer should also consider the dynamic social forces which are fast changing the world. Before accepting long term bonds of a private corporation, he should ask himself whether it is performing socially useful work and likely to be permitted to continue. When the people of the United States decided that private property in negro slaves was against the public interest, they abolished the institution and the owners suffered great financial losses. The coming of prohibition also destroyed the value of much liquor property.

In the case of foreign government bonds, the investor should be sure that the borrowing government is based on the consent of the governed, and is likely to survive until the bond matures.

In a time of precipitate change like the present, the investor should think much of safety. But safety is a relative concept, and all the investor can hope to do is seek to determine what is the best on the market.