3. Refunding versus amortizing.—When the se curity behind a bond issue remains constant or in creases with time, and the company desires to retain the use of the capital which bondholders have invested, a definite maturity date for the whole issue is ordi narily fixed for a term ranging between twenty and one hundred years. Railway bonds furnish the best example of this class. The company does not expect to retire the debt when it matures, but it does expect to pay the individual bondholders. The payment of the bondholders, at the same time renewing the debt, is accomplished by a process called refunding, which means merely that another bonded debt is created, from the proceeds of which the maturing bonds are paid off. The old bonds are superseded by a new issue and the company continues in the uninterrupted enjoyment of the capital.
The principal purpose of frequent refunding is to adjust the debts of the company to changes in the condition or extent of its assets or business, or to improvements in the bond market. A railroad, for instance, which borrowed in 1900 at 4.5 per cent, may be able, owing to its improved credit, to refund in 1920 at four per cent, thus saving annually thereafter a substantial amount in fixed charges. This explains why, while high money rates obtain, corporation notes, or bonds of short maturity, are sold instead of long-term bonds, and why it is customary to make the bonds redeemable at the option of the corporation.
To refund a debt means to renew it in new form, but to amortize a debt means actually to pay it off. The full debt can probably not be paid out of the current profits or liquid assets available at the time it matures. Therefore, if the debt is actually to be paid off, some provision must be made for gradually retiring the bonds, or accumulating a fund with which to retire them at maturity. This process is known as amortization. Bonds are amortized, as a rule, only when it is felt that they cannot be refunded; in other words, when they are based upon a diminishing asset, or upon a business which is not regarded as possessing great stability. The business itself may be a good one, and yet subject to such rapid change or develop ment that assets mortgaged now would be practically worthless ten years hence. Manufacturing assets are for this reason difficult to borrow upon for long ma turities. When secured by wasting assets or dimin ishing earnings, the necessity of bond amortization is clear. Whether the reduction results from dimin ished quantity, quality or earning power of assets, is immaterial.
4. Basis of amortization.—The security of a loan
may consist of the market value of a product, struc ture, or natural resource, or of the earning power of a business. The bonding value of property of any kind is based upon its productive capacity, or "value in use." An asset is worth only what it will produce. If, in the course of production, the value of the spe cific security declines, it becomes necessary that the bonded debt be retired at least as rapidly as the assets upon which it rests are consumed. Such assets are known as wasting assets. Any natural resource or stock of goods which is exhausted in the course of busi ness is a wasting asset.
Any specific structure or piece of equipment is a wasting asset, because deterioration caused by time or use, or both, is inevitable. On the other hand, a given lot of equipment which is being constantly replaced and improved, so that its productive value as a whole is maintained, may not be considered as a wasting asset.
The basis of amortization is therefore found in the nature of the security pledged, by allocating the causes of the wasting values. These causes are three in number: 1. Depreciation in earning power, caused by time or operation 2. Reduction of assets by sales 3. Decline in value owing to changes in the mar ket.
Resulting from the nature of these causes, there are two bases of amortization: 1. Upon the unit of time—debt amortized at a certain rate per year, or other unit of time 2. Upon the unit of production or sale—debt amortized at the rate of so much per ton of coal mined, per thousand feet of timber cut, per acre of ground sold, etc.
To illustrate.—Bonds upon specific railroad equip ment or single steamships usually mature serially, and are paid off in perhaps ten even annual payments, because time is the chief cause of their deterioration. Coal bonds are retired out of a fund accumulated at the rate of from three to five cents per ton mined, because production, which reduces quantity on hand, is the factor determining the diminution of the se curity.
Failure to observe these underlying principles and to distinguish clearly between them has resulted in numerous unsuitable, and often unsuccessful, pro visions for amortizing bonds. It should be observed that the first and third causes, above mentioned, pos sess a sufficient element of uncertainty to produce wide divergence of opinion. The rate of obsolescence, or market decline, is purely speculative in most cases. Frequent errors of judgment in the rate of amortiza tion, therefore, often result, even when the govern ing principles are clearly recognized.