Conditions governing conversion are nu merous, and the profitableness of convert ing under allowed conditions is a matter of calculation. Convertible bonds offer a large enough field for a volume to themselves. We shall examine only several prominent issues to get an idea of the working of the class. The purpose of making any security convert ible into one of junior rank is to gain present safety combined with a chance to get some of the benefit of speculative profits on condi tion of giving up the preferred position.
We would call attention to the fact that the idea combines present safety in the senior security-holder with the benefit of sharing future speculative profits. The holder of a participating security does not have to give up the preferred position to enjoy the greater income, and in that respect the common shareholder has made a less advan tageous bargain. In the case of a convertible security, if the holder takes a share of the en hanced profits, he has to give up his advan tageous position as to risk. The common shareholder has then lost some of his profits, but has gained a position of less risk. Take a concrete case to show the point: Suppose two corporations, A and B, capitalized: Corporation A Corporation B $5,000,000 6 per cent convertible bonds. 19,000,000 5 per cent participating bond. 5,000,000 common stock. 5,000,000 cowman stock.
Suppose in corporation A the bonds may be converted into common at 150, and that when the corporation makes 10 per cent on its total capitalization the stock does go above 150 in the market.
In corporation B the bonds participate equally with the common above 5 per cent.
Assume that in both corporations earnings advance to 10 per cent on the total capitaliza tion, and in corporation A none of the bond holders convert. Then: Corporation A Corporation B Net $800,000 Net $800,000 Interest 150,000 Bondholders get . . . 300,000 Surplus 650.000 Shareholders get . . . 800,000 Bondholders get . . 5 per cent Bondholders get . . 10 per cent Shareholders get . . 13 per cent Shareholders get . . 10 per cent In corporation A the bondholders cannot share directly in the prosperity of the com pany without giving up their priority. Sup pose they all convert. They get 5 per cent more income and the shareholders 3 per cent less and all security-holders get 10 per cent, the same as in corporation B.
Now suppose a severe depression in the business sets in, and earnings on the total capitalization drop to 3 per cent. Then: Corporation A Corporation B Net $240 000 Net $240,000 Former bondholders, now shareholders, get . . S per cent Bondholders get . . 5 per centFormer shareholders and Shareholders get . . 1.8 per cent still shareholders get . 3 per cent If net earnings should drop 2, per cent more, they would not be sufficient to pay the 5 per cent to bondholders in corporation B. The shareholders' equity is wiped out, and the bondholders would get control. In corpora tion A the former shareholders would still be getting 1 per cent and cannot be wiped out.
So much for the advantage to the common shareholder of the convertible bond over a possible bond with a participating stipula tion. It has the disadvantage of projecting another element of uncertainty into the affairs of the corporation. It adds something incalculable from the financial scheme to the already many incalculable considerations in the nature of the business. As a matter of fact, for example, not every convertible security-holder gives up his priority in order to gain a greater income. Very many do not. The directors of the corporation cannot calcu late how many will. They cannot foresee just
how much will be required for interest, and consequently how much available for divi dends and how many shares it will have to be distributed among. On an actual conver sion also the common shareholder suffers a lessening of the quantitative control in his stock. In the case of corporation A we have just taken, the shareholder having 10,000 shares starts out with one fifth of the active control. If all the bondholders convert, this owner of 10,000 shares finds that he now has only one eighth of the active control. This Makes a very appreciable difference in the value of his holdings from a control stand point.
Some specific examples of convertible bonds are: Atchison, Topeka & Sante Fe convertible debenture 4s, due June, 1955. They are re deemable on any interest date after pub lished notice at 110 and interest, and are con vertible at par, at any time prior to June 1, 1913, into common stock at 100. If they are called for redemption in the mean time the conversion privilege may be exercised, but not later than May 31, 1913, and shall cease upon the day preceding the one named for payment. At the time of writing, the stock is on a 6 per cent dividend basis and selling at 103. The right of conversion is operative. A thousand-dollar bond can be exchanged for ten shares of stock worth $1030. We should expect to see the bonds selling at 103. As a matter of fact, they are selling at 1041. Con vertible bonds do not always follow the price of the stock down. Notice, too, that it does not follow that a convertible security will al ways be converted as soon as it is profitable to do so. These Atchison bonds cannot, at the time of writing, be considered worth more than par on their merit as an invest ment.
Delaware & Hudson Company convertible debenture 4s, due June 15, 1916, are convert ible up to June 15, 1912, into common stock at 200. The stock pays 9 per cent and is sell ing at about 162. Since the bonds are worth on their investment merit 978, the price they are selling at, the stock would have to ad vance above 1941 plus commissions in order to reach a profitable conversion point.
Union Pacific Railroad Company convert ible debenture 4s, due July, 1927, are redeem able as a whole, but not in part, on or after July 1, 1912, at any interest date after ninety days' notice, at 1021. The right of conversion continues up to thirty days of the date of re demption. They are convertible at par, on or prior to July 1, 1917, into common stock at 175. The bonds are selling now at 101, some what above the present investment value, though the stock is selling at only 161, or considerably below the par of conversion.
Pennsylvania Railroad Company convert ible debenture 31s, due October, 1915, are redeemable at 100 and interest at any interest date on ninety days' notice, with a right to convert up to thirty days before the redemp tion date. They are convertible at any time into stock at 75 (par value, 50), equivalent to 150 as quoted on the New York Stock Ex change. The bonds are selling at 96i, the stock at 1201. The bonds would have to be at 80 in order not to lose by conversion with the stock at that price.
American Telephone and Telegraph Com pany convertible debenture 4s, redeemable March, 1915, or on any dividend date there after, on twelve weeks' notice, at 105 and interest, with the right of conversion contin uing up to thirty days of date of redemption. They are convertible, up to March 1, 1918, at par into stock at 126.44. The bonds arc selling at 106, or away above the investment value.