Sometimes borrowers are hampered by arbitrary sinking-fund demands on the part of investors, who, lacking faith in the future of the bUsiness, seek rapid amortization as a protection. The protection that they should actually have, in such cases, is often not amortization at all, but an intelligent policy govern ing capital investments, maintenance, surplus and dividends. Bonds should never be amortized with out good reason, but when amortization is necessary its true principles should be recognized and applied.
5. Test of amortization.—The desirability of any given plan of amortization may be tested by the fol lowing five considerations : 1. Adequacy of the sinking fund or redemption payments 2. Certainty of payments 3. Reasonableness of the distribution of the burden upon the corporation 4. Effect of the plan upon the market for the bond 5. Expense and labor involved in the plan.
The application of these considerations will pres ently be shown. It will be noted that the first two are for the protection of the creditors, and that the last three are important to the borrowing corporation.
The creditor is interested in knowing that the plan is enforceable, the payments certain, and the amort ization provision ample to protect him against any decline in the value of the security. The borrow ing corporation is interested in securing a just, grad ual and perhaps even distribution of its payments, so that it may be able to make them out of income with out distress. The company also desires a plan which will involve as little inconvenience, uncertainty and expense as possible, and which will enable it to market the issue to the best advantage.
6. Methods of am ortization.—The methods of amortization may be summarized as follows: (a) Retirement in series or by allotment.
1. Bonds maturing serially 2. Periodical retirement by purchase in open market 3. Periodical retirement by allotment and advertisement.
(b) Redemption fund accumulated against ma turity.
1. Fund held by trustee in bank 2. Funds invested by the trustee in out side securities 3. Funds invested by the trustee in bonds of the same issue, which are kept alive in the fund.
It is a good policy for a corporation to borrow, and for the same reason it is a good policy not to amortize the loan under any plan unless it is demanded by in vestors or by the nature of the risk. If the profit of the business or the value of assets is enduring enough to justify the expectation that the protection of the bondholders will remain constant or increase, it is usually unwise to provide for amortization. Serial
repayment is a clumsy device, not frequently used when it can be avoided. Amortization by redemp tion fund is more frequent. The words "sinking fund" possess charm to many investors, who perhaps consider them a sort of life-saving device, much as the housewife regards her "Christmas fund" at the bank.
7. Unnecessary sinking funds a source of loss.—If the funds are held in cash by the trustee under the mortgage, the amount in bank will not average over 3.5 per cent interest, whereas the company is perhaps paying 5 or 6 per cent upon its bonds and losing the difference. If the sinking fund is used to buy and retire its own bonds, the company is in the position of taking capital out of its business, which is earning perhaps upward of ten per cent, in order to save five per cent interest, and of course the difference is lost. If the trustee invests the sinking fund in securities other than those being amortized, he can not expect to earn safely more than four or five per cent thereon, and the company loses the difference between this and its own rate of earnings. Further more, if the funds are invested in outside securities, the company takes the risk of stock market fluctua tions and of tying up the funds so that they will not be available to meet the bonds at maturity. Unneces sary sinking funds, therefore, bring loss to the cor poration.
The investor himself often loses security in de manding sinking funds, for the reason that the in creased earnings of the business, resulting from rein vesting profits in productive assets instead of set ting aside a sinking fund, will frequently increase his margin of security. Especially is this true if the sinking fund requirements impair the ability of the company to maintain its plant in the best condition and operate on the most efficient basis.
If there is no redemption fund, restrictions upon dividends may be necessary in order to make sure that the surplus earnings go back into the property rather than into the pockets of stockholders. Need less to say, sinking fund requirements always depress stock values, since they constitute a fixed charge which frequently makes dividends impossible.