The Financial Situation

Reasons For the Change of Tempo in the Bond Market

MERRYLE STANLEY RUKEYSER

IN recent months there has been a change in the tempo of the bond market. The period of dramatic and unprecedentedly swift price movements has passed. Instead of precipitate and cataclysmic fluctuations, the declines and rallies have been almost imperceptible.

The investment price structure, which had been transformed into a thing of rapid and interminable flux by the torrential economic forces loosened by war and reconstruction, has at length become stabilized. The time for scare-heads, on the one hand, and captions flaming with flamboyant optimism, on the other, has passed. The bond market has returned to a prosaic condition.

Investing has once more become scientific and comparatively lacking in excitement. The old criteria by which good bonds were judged—safety of principal and assured regularity of income—are again fair standards. The opportunity for speculating in non-speculative securities has passed. Already buyers of high grade bonds are thinking more regarding the ability of the borrowing corporation or government to repay its obligations and less of the prospects for a rise or fall in the market price of the engraved promises to pay.

FROM midyear in 1921 until November 1922, the bond market was like an inverted Niagara Falls, with the stream of prices rushing madly and relentlessly upward. The surge of quotations came after a period of equally drastic declines. The ebb and flow marked the reflection in bond quotations of the broader movements of inflation and deflation of credit and prices for commodities.

The present financial situation represents no deadlock—no cessation of the operations of the forces of supply and demand. No millennium of quietude and immobility has been attained. The transition has been relative, instead of absolute. Prices still fluctuate incessantly, but the bond market, after abnormal years of unusually wide price swings, has reverted to a phase of more normal and less drastic fluctuations.

These generalizations apply primarily to high grade bonds about whose safety there is little or no skepticism. Such securities rise and fall with basic interest rates. Less gilt edge issues change in price also in accordance with factors which suggest the increasing or decreasing faculty of the borrower to meet its obligations. French government bonds, for example, fluctuate with the news concerning an adjustment of the economic riddle regarding German reparations. Bonds, such as the obligations of the venders of fertilizer, grow more popular at the marketplace as the economic condition of the farmer improves. Bonds, which are fundamentally affected in price by other factors than interest rates, are not pure investments, and in an infinite variety of degrees partake of some of the speculative characteristics of shares of stock, which rise in times of prosperity and fall with or just before adversity.

Intensive prosperity, on the other hand, has a detrimental effect on the market value of high grade bonds. Great prosperity involves an expansion of business activity, which ordinarily involves inflation of credit, firm prices for commodities, and ultimately rising interest rates. The check in the rise of bond prices recently was coincident with a betterment of trade conditions, and the course of bond prices for the remainder of 1923 depends primarily on the course of business.

According to present indications, the banking authorities have such a firm grip on the credit situation that it seems wholly unlikely that there will be any unrestricted expansion of credit. Moderate inflation, on the other hand, may reasonably be expected, and the outlook for bonds is for fluctuations within relatively narrow arcs, with possibly further moderate reactions.

The permanent investor thinks of yield rather than market value. His money will now bring an income of 5 1/2 per cent on the average, if a moderately high degree of safety is sought. To the man who buys bonds now and holds them until they are paid off in full, market fluctuations in the interim are of academic interest only. There is no discernible data on the horizon of the investment markets which indicate that it would be unprofitable or dangerous to buy bonds now. On the other hand, the penalties of waiting, if there be any, will be incalculably less than those which would have been experienced a year ago. The astute trader, who aspires to take advantage of every eighth, might well be tempted to buy short term paper and be in a position to shift into longer bonds at the ebb of a downward reaction.

Outstanding bonds must compete in attractiveness with new offerings, and the yield on the old and new inevitably become almost identical. A variety of factors obviate the likelihood of a sudden drift into a period of superabundant credit such as prevailed at the opening of this century when high grade railroad bonds sold on a three per cent yield basis. The hunger for capital abroad is a factor in determining interest rates, for, with America transformed into a creditor nation, the whole world competes with domestic corporations for the savings of the nation's investors. Moreover, as long as the privilege of tax exemption goes to municipal and state issues and as long as high income taxes make the tax feature the determining factor in selecting the investments of the rich, corporate borrowers will have to pay relatively higher rates. Moreover, for a year and a half commodity prices have tended upward, and the end is not yet clearly in sight. Firm commodity prices tend to strengthen interest rates as it heightens the credit needs of business enterprises.

Of course, the historic rise of bond prices which was checked last Fall was tremendously facilitated by the rush of commercial banking funds into the investment market while trade was relatively quiet. Some banks had to sell parts of their bond holdings, but the ability of the banks to get loanable funds more advantageously through the rediscounting of commercial paper at the Federal Reserve Banks restricted this character of selling. Moreover, while business was inactive, strong corporations with idle funds bought bonds, and subsequently found a use for such capital in their own business operations.

EXEMPTION from taxation, a privilege enjoyed by state, municipal and certain Federal Government bonds, results in many anomalies. It makes the more than comfortably rich—who are likely to be the main supporters of capitalism and private initiative in business— invest nearly all their surplus in securities to finance the activities of Governments. Under the goad of high income taxes, the rich have in recent years discriminated in an unprecedented manner against the obligations of private corporations.

President Harding and Secretary Mellon think the further issuance of tax free bonds ought to be stopped—by a constitutional amendment if necessary.

In addition to deranging corporate finance and greatly influencing the fiscal aspects of government, the tax free clause in specially privileged bonds interferes with many of the social objectives of taxation. Continued indefinitely, the tax free bond might divide the nation into two great classes—those who pay taxes, on the one hand, and those who buy tax exempt Federal, state, and municipal securities, on the other. The tax exemption is not especially attractive to the man with an annual income of less than $35,000 a year, and the continuance of the present system therefore places a disproportionate burden on the moderately well to do and the poorer classes. Moreover, it incidentally tends to remove municipal bonds, the best of which are the highest type of investment for all classes, from the field of attractive bonds for the small investor. If the tax exempt feature were discontinued, such government bonds would sell purely on their investment worth, and would in an increasingly degree become desirable for the person of small means who needs safety but not exemption.

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As Dr. E. R. A. Seligman, noted economist and expert on taxation, has observed, "The objection to tax exemption is that it creates a gross inequality of burden. To the extent that these bonds form an increased share of the realized property of the nation, tax exemption means the liberation of unearned incomes at the expense of earned incomes. We may not in this country be ready for the principle, which has been adopted nearly everywhere else, namely, the principle of differentiation of taxation, whereby lower rates are granted to labor or earned incomes than to property or unearned incomes. But it is certainly true that no country has ever seen fit to tax property or unearned incomes at an actually lower rate than earned incomes. Yet that is actually what we are doing.

"In addition to this glaring inequality, we have a still worse situation, namely the escape of the rich man from the burden, which must, accordingly, be borne by the poor man, and by the recipients of moderate incomes. With the exceedingly high surtaxes in our present income tax, making the entire tax rise until recently to 77 per cent and now to 58 per cent the temptation on the part of the wealthy to invest in tax exempt bonds becomes almost irresistible. The result is a progressive falling off in the numbers and amounts of taxable incomes in the higher incomes scales."

At present, there is outstanding nearly $10,000,000,000 of tax free bonds of American states and municipalities, with an annual increase at $1,000,000,000 to $1,500,000,000. At this rate of growth, by 1926, when most of the outstanding Federal bonds lose their tax exemption, the total of tax free securities of states and subdivisions may reach $14,000,000,000 to $17,000,000,000, according to capable estimates.

The exemption of outstanding issues probably cannot be disturbed, for to do so would likely be at variance with the constitutional provision against passing laws which impair the obligations of existent contracts. The American democracy, however, is at liberty to determine its policy regarding new issues.