AMORTIZATION OF BONDS 1. Necessity for the amortization of bonds.—It is desirable, if the terms are advantageous, for corpora tions to borrow upon long-term bonds. When cor porate notes or other short-term obligations mature, they are expected to be paid. When bonds mature, the debt is not usually retired, but is refunded by a new issue of bonds. Naturally these refunding op erations are attended with some expense, inconven ience and uncertainty. From this, at first thought, it might seem logical that corporate bonds, when pos sible, should be made perpetual; that is, without any stated term or date of maturity.
The so called British Consols, originally issued by the British government to refund various maturing war bonds, are perpetual. The government, by pur chasing the bonds in the open market, may retire the debt, but there is no fixed date upon which the holders of the consols are entitled to demand payment. Many British railway debenture loans are also per petual. There are a few instances of perpetual loans in the United States, as, for example, the $20,000,000 issue of the Public Service Corporation of New Jer sey's perpetual interest-bearing certificates.
Perpetual loans, however, do not accord with the American custom. Entirely aside from considera tions of security, there are good reasons why bonds should have definite dates of maturity. Technically speaking, there is no such thing as a perpetual loan, as no advance of funds is a loan, or credit, unless accompanied by a definite obligation to repay. There is no obligation to repay a perpetual loan, ex cept upon liquidation of the company's affairs. If no right resides with the creditor ever to demand pay ment of the principal, the advance amounts practi cally to the purchase of an annuity, payable perpet ually to the extent of the annual or semi-annual in terest.
Loans have definite dates of maturity, for the fol lowing reasons: 1. To enable the investor to ascertain occasion ally by actual test the solvency of the obligor 2. To broaden and strengthen the bond market. Constant refunding keeps the market active, stimulates long-term borrowing, and leads to more efficient management as a credit ne cessity 3. To steady bond prices ; perpetual bonds fluctu ate in price in inverse ratio with the true market rate of interest upon such investment securities, while bonds with definite maturi ties are, as a class, tied quite closely to par or redemption values To adjust the amount, form, security, or in terest rate of the loan to the changing condi tions or necessities of the corporation, or of the market.
2. Effects of definite maturity upon bond prices.— Altho it is explained more fully in the volume on "In vestments," it is necessary here that the reader un derstand the effect of bond maturities upon market prices. The bond investor seeks safety, and a certain definite income in the form of interest. The interest is based upon the par value of the bond, but the in vestor may pay more or less than par for it. The real rate of interest which he receives, known as the yield, is therefore determined roughly by dividing the actual amount of annual interest by the actual cost of the bond. If, for instance, a perpetual bond bear ing four per cent interest sells at par, one with equal security and marketability bearing three per cent interest ought to sell around 75. The yield upon the investment would be four per cent in both cases.
With a ten year maturity, however, the three per cent bond would not sell as low as 75, to yield four per cent, but would have a market value around 90. If it did sell at 75, the yield would be about 5.5 per cent, because there would be added to the 3 per cent interest about 2.5 per cent annual appreciation in value, due to repayment in ten years at 25 per cent more than the cost of the bond to the investor. The three per cent bond, maturing in ten years, would therefore sell, other things being equal, about fifteen points higher than the three per cent perpetual bond. The difference is due to the early maturity of the ten year bond and to the fact that it was purchased at a discount. The nearer an issue of bonds approaches maturity, the narrower will be price fluctuation above or below par, since the premium or the discount con stitutes an element in the yield. As the market yield upon good bonds goes up, the prices of existing issues, as a whole, go down. The reverse is also true, prices of bonds increase as the market rate of interest de creases. American investors usually prefer the sta bilizing influence of definite maturities to counteract this speculative influence of the market.