9. bonds are formal in terest-bearing obligations whose security depends upon no specific property, but upon the credit of the company and the surplus earnings over and above interest charges. It is therefore apparent that large issues cannot be marketed except by companies hav ing the highest standing, such as the Michigan Cen tral Railway, the New York Central, and the Lake Shore Railway. This type of security is scarce in the United States, but is frequently used in Great Britain. Interest is usually not cumulative. The lien along with that of other unsecured creditors comes after bonds and before stock.
10. Income income bonds come into existence as the result of the scaling down of mort gage bonds in the processes of a railway receivership. They are a claim to a fixed income for a certain period, provided that income is earned, after operat ing expenses, including maintenance, interest and sinking fund payments on all prior bonds, have been paid. If the income is not paid the only thing that can be done is to enter suit for an accounting; a fore closure cannot be forced. Accordingly, this security is a sort of preferred stock with a fixed dividend, not cumulative, and not possessing a vote. As a type it is disappearing from the market, for it is the weakest variety of bond. It should be let alone by the average investor.
11. Convertible bonds are usually unsecured debentures, the holders of which are given the privilege of converting their security into some other security of the issuing company. The usual privilege is that conversion may be into common stock at par, at the holder's option within ten years. The security thus created is a combination of a loan and an option. If a bond is convertible into stock at $175, like the Union Pacific 20 year convertible 4 per cent bond, due 1924, it means that the par value of the bonds may be applied toward the purchase of the stock at the price of $175 per share. It would there fore take $17,500 in bonds to purchase $10,000 in stock, or 100 shares. The conversion ratio is then 100: 175. If the stock were selling at $160, the bond, on its conversion right, would be worth 100: 175 : : x : 160 = $91.40. If the stock sold at $200 the bond would be worth for purposes of exchange 100: 175: : x: 200 = $114.30.
The first convertible bond was issued by the Erie Railroad in 1843. The idea was popular in railroad finance from 1860 to 1880, after which time it fell into the background. Since 1900 it has again come into
favor. Convertibles are a means of keeping down fixed charges temporarily by marketing a bond at a lower interest rate than would be accepted otherwise. In recent years they have been a means of insuring the investor against the effect of the declining pur chasing power of money by giving him the right to convert his security into one which will share in earn ings, and so follow the course of business profits rather than the course of interest rates. Corpora tions sometimes issue convertible bonds to avoid the necessity of issuing bonds with higher interest rates than their bonds already outstanding. As the con version takes place when stocks are high, and hence presumably when business is good, this type of bond broadens the stock basis and decreases the fixed charges, as pointed out above. Furthermore, it re leases some mortgaged property, and so makes way for new bond financing at a time when additional funds are likely to be most needed for expan sion.
The principle of fluctuation is that when the stocks are at or above the conversion price the bonds rise and fall with the stocks in the ratio that is prescribed for conversion. But when the stocks are below the conversion price the bonds rest upon their security and interest yield as junior liens. Convertible bonds have been called a balloon with a parachute attach ment. This peculiarity in the fluctuation of convert ible bonds has led to a type of market-scalping in which the trader who anticipates a severe decline goes short of the stock and long of the bonds. His ex pectation is that if the stock declines the bonds will not do so correspondingly, while if the stock advances the bonds will advance in equal measure if the con verting ratio is par for par. The history of the Atchison, Topeka and Santa Fe Railway convertible 4s of 1955 during the decline of 1907 and the rise of 1908 and 1909 furnishes an interesting example. When the movement of these bonds is taken in rela tion to the fluctuations of common stock (into which the bonds were convertible at par) and in relation to the adjustment 4s due 1995 (similar in character to a junior lien) it can be seen that the convertible bond acted as a junior lien at and below 86, and as a stock above 115, while between these two limits the influ ence controlling it was a composite of the two.