A debt results from an agreement however, and it is an old maxim that it takes two par ties to make a bargain. So far we have dis cussed only the considerations affecting one party, the debtor corporation. What the cor poration may consider adequate for the de mands of prudence, the creditor party may not deem nearly equal to his desire for safety. For example, if the value of a special asset pledged as security decreases from its very nature, as in the case of the railway equip ment or the steamship, the creditor will not rest satisfied with any less assurance of the maintenance of the equity than that given by serial repayment. Amortization in this way requires that certain of the bonds defin itely fall due each year. Since failure to pay the maturing bonds constitutes a default of principal, with the consequent loss of right to control the property, a corporation cannot fail merely as a matter of convenience to keep up the amortization.
Though amortization may not be so import ant to the creditor in cases other than those already mentioned, he may nevertheless re quire it as a condition of investing. Stating the actual situation more nearly, the banking house arranging to finance an issue of bonds may insist on a sinking-fund as a measure of protection to their clients. That leads im mediately to the main part of the discussion. Assuming that the debt is to be amortized, in what manner shall the corporation provide for its repayment ? For the sake of facilitating statement, the discussion will assume the common case of a corporate debt represented by bonds and se cured by mortgage to a trust company for the benefit of the bondholders. Principles of amortization, however, would be the same for other forms of debt as for that. Several questions will test the merit of the plans of amortization now in use.
1. What gives assurance that the stipula tions for amortization will be carried out ? 2. How will the amortization provisions affect the market for the security ? 3. How evenly do they distribute the bur den of the debt ? 4. What work do they involve in carrying them out ? 5. What assurance do they give that they equal the requirements ? 6. How does the cost to the corporation compare with that of other forms of amortiza tion ? To explain question 3, — the burden of a debt comprises the obligation to pay interest and the obligation to pay principal. Serial repayment and sinking-funds have for their very purpose the distribution of this burden of principal payment over a period of time. Since principal payment, however, makes only part of the burden, the manner of dis tributing this may disturb the equality of in terest payment and result in an uneven dis tribution of the whole debt burden. Ideally
the burden of principal and interest combined should weigh evenly through the period of the debt.
Methods of amortization fall under several heads: — (a) The bonds may mature serially.
(b) The corporation may build up a re demption fund by depositing cash with the trustee.
(c) It may invest the redemption fund in securities other than those it has issued it self.
(d) It may use the fund to purchase securi ties of the issue being amortized.
Serial maturity meets with an objection in the answer to the second of the test questions — as to the effect of the amortization provis ions on the market for the security. Such a ma turity makes impossible a uniform quotation in terms of price, and, therefore, with one or two other considerations affecting the mat ter, makes difficult the creation of an active market such as exists on the stock exchange and through street trading in many securities capable of a uniform quotation in terms of price. Take, for example, the New York Cen tral Railroad equipment 41- per cent bonds, due serially from January 1, 1911, to January 1, 1925, inclusive. A price quotation for the entire issue except par (100) would be impos sible. Anywhere below par the bonds having the shortest time to run are worth the most in terms of price. That is to say, a 41 per cent bond having only three years to run would sell at 99.17 in order to yield 4.80 per cent. If it had nine years to run it would have to sell at 97.83 in order to yield 4.80 per cent. Without making any allowance for the invest ment demand at the time running to short term or long-term securities, if the nine years' bond were worth 97.83, then . the three years' bond would be worth 99.17.
A uniform quotation can be given, to be sure, in terms of basis, as, say, "any matur ity, price to yield 44 per cent," or "price to yield 4: per cent, less one eighth." Such a quotation is too technical for any but the ini tiated buyer. It involves too many consider ations. Furthermore, fashions of investing, as already indicated, throw out of gear the possibility of quoting uniformly in even such a complex manner. As a matter of fact, de pending on a good many considerations, in vestors at one period show a preference for short-term securities, at another for long term. During a time of short-term invest ment preference, a bond due in two years might command a 41 per cent basis, but one of the same serial issue due in ten years might not command better than a 41 per cent basis, less one fourth; that is to say, a quarter of a point lower in real price than the shorter maturity.