Part 2

There is no mystery involved in determining the safety of railroad bonds. Any man of business experience, keeping in mind the general 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, 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 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 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 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 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.

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.