[40]

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[41] 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.[42]

(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;[43] 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[44] 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[45] 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 ½ per cent to ¾ 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[46] 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[47] 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[48] 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 5½ 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 6½-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[49] 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 4½ 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 93¾ and would represent 6¼-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[50] 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.