[23]

II

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.[24]

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.[25] 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[26] 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[27] 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:

(1) Rate per mile at which the bond is issued. Applying the general principle indicated above, it must be learned what proportion the bonded debt of a railroad bears to the total market value of the property. It is much easier to make this comparison on a per-mile basis. In determining whether the rate per mile is excessive, reference must be made not so much to the particular bond in question as to the total bonded debt per mile of the railroad,[28] and to the relation which that figure bears to the total market value of the property per mile. The total market value per mile is obtained by adding the market value of the stock per mile to the par value of the bonded debt per mile. A single issue of bonds varies all the way from $5,000 to $100,000 per mile, according to the location of the railroad. Total capitalization per mile—stocks and bonds at par—varies in about the same proportion, from $35,000 to $300,000. The average for all the railroads of the United States is $67,936 per mile. The actual cost of the railroad, as shown by the balance-sheet, must be taken into consideration, and also the estimated cost of duplicating the property. Physical difficulties of construction must be weighed, for a railroad through a flat, sandy country should not be bonded for as much, other things being equal, as a railroad through a mountainous country, where much cutting, filling, and bridging are required. The section of country in which the railroad is located must be considered, for $35,000 per mile on a single-track line in a poor country may be higher than $300,000 per mile on a four-track trunk line which owns valuable terminals[29] and rights of way through several large cities.

(2) Amount of prior lien bonds outstanding per mile. The amount of bonds which come ahead of the bond in question on the same mileage is a matter of great importance and works directly against the security of the bond. Purchasing a bond which is preceded by a prior line bond is like taking a real-estate mortgage on property already encumbered. If the bond is not followed by other bonds, then the margin of security in the property is represented wholly by the market value of the stock per mile, and the investor must figure carefully the value of this equity.

(3) Amount of junior lien bonds outstanding per mile. The amount of bonds which come after the bond in question, on the other hand, works directly in favor of the bond, for it increases the margin of security. It shows also that other people have had sufficient confidence in the property to invest their money in obligations subject to the one in question. In the event of a receivership this is often a matter of great importance; for if a foreclosure sale is ordered the junior bondholders, in order to protect[30] their own interest, must buy in the property for an amount at least equal to the par value of the prior lien bonds.

The foregoing considerations apply particularly to the safety of the principal invested in railroad bonds; the following points affect the safety of interest:

(4) Gross earnings per mile. The gross earnings of a railroad must be compared with those of other roads occupying the same field, and the returns for a number of years must be examined to determine whether such earnings have increased or decreased. The position in which the railroad stands for obtaining new traffic must be noted. This is dependent somewhat upon the railroad's ability to take traffic from other railroads, but more upon the probable growth and development of the territory which the railroad serves, and the increased traffic which will probably be offered. In this connection the rate of increase in population in the road's territory is important. The proportion between passenger and freight earnings, the diversity and density of freight traffic, and passenger and freight rates should be examined. The reputation of the management[31] for ability and integrity should be considered. Gross earnings run from about $3,000 to $40,000 per mile with the average $10,460.

(5) Net income per mile. Net income is obtained by subtracting from gross earnings operating expenses (and sometimes taxes) and adding to the net earnings so obtained whatever income from other sources the railroad may derive. This is a very important figure. As with gross earnings, the reports should be examined to determine whether net income is on the increase or the decrease, and it should be compared with the net income of other railroads occupying the same field. It involves a criticism of operating expenses. The payments of the railroad must be analyzed to determine whether the proper sums have been expended for maintenance of way, replenishment of rolling stock, and other improvements sufficient to keep the road in good physical condition. Normally speaking, operating expenses should absorb about 65 per cent of gross earnings. If it is found that a railroad operates for 60 per cent, however, it does not always follow that its operating officials are exceptionally efficient, so that the cost of conducting transportation is relatively[32] small; it may mean that the physical condition of the property is being neglected, or that ordinary improvements, which should be charged to maintenance, are being paid for by increase in capitalization. It is very important for the investor to find out which is the case. If analysis leads to the suspicion that the earnings result from neglecting the property or capitalizing every trivial improvement, the railroad's bonds should be rejected. Net income varies from $1,500 to $12,000 per mile, with an average of $4,702.

(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.[33]

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[34] 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[35] 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 [36]for recent issues. The figures showing the market value of stocks are based on the amounts outstanding April 1st, 1908, at the market price.

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[37] 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 3¾ 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.[38]

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.[39] 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.