Since debentures depend for their value upon the earnings of the company, another protection often ex tended to them is the guarantee that the proceeds of the issue will be invested in productive assets in such manner as to increase earning power. This restraint upon management of income is also applied to pre ferred stocks, as we shall see, and it constitutes an element of real strength.
2. Convertible bonds.—A convertible bond is one which may be exchanged by its owner for capital stock, either common or preferred as the case may be. The exchange privilege may be limited within certain dates stated in the bond, or it may extend over the full term of the issue.
The conversion ratio, or price, is always stated in the bond, or trustee's agreement, as, for instance, ten shares of stock for one bond, par for par. Naturally, if the stock rises to a higher market value than the bonds, the bond owners will take advantage of the conversion privilege to make a speculative profit on their holdings. Once the price of the stock exceeds the normal market value of the bonds, the prices of the two will move upward together, with the bonds a trifle lower than the stock. However, if the price of the stock falls below the market value of the bonds, the latter will not continue to decline with the stock.
Since earnings constitute the greatest single factor in determining the values of both stock and bonds, the prices of debentures will naturally be depressed by any influence which causes the stock to decline, but the downward movement of the bond will be less marked because it supersedes the lien of the stock and matures on a given date at par. The stabilizing in fluence of definite maturity upon bond prices will be explained in the next chapter.
Altho debenture bonds do not accord with the American custom, some large issues of convertibles, such as the five per cent convertible gold debentures of the Atchison, Topeka and Santa Fe Railroad, have found growing favor because of the combined invest ment and speculative feature found in the conversion privilege.
3. Participating bonds.—Another form of specu lative privilege attached to bonds, by which the bond holder may share with capital stock in the surplus profits of the company, is known as the participation privilege. In addition to their stated interest, par ticipating bonds receive a certain proportion of the surplus earnings of the company after the stock holders have received a stated dividend. It may be provided, for instance, that after the bonds have re ceived five per cent, stockholders shall next receive six per cent, and the additional earnings available for distribution be divided equally between them. Usu
ally there is a maximum participation, above which all surplus profits go to the stockholders. The vari ous plans of participation are too numerous to de scribe, but they are all based upon the same principle and purpose.
The participation privilege is used to make weak bonds more palatable to investors. It is a provision found mostly in industrial issues, which appeal to the semi-speculative classes. They desire the safety of a bond, but are willing to take reasonable risks in ex change for the opportunity of participating in the sur plus profits. The owner of the participating bond, unlike that of the convertible, does not jump from one extreme to the other, from creditor to stockholder, but retains his preferred position as a bondholder. Security and other conditions being equal, speculative profits are more limited upon participating bonds than upon convertibles, because participating bonds are tied closely to par values and depend for speculative profits mainly upon participation, instead of market in crease. Participation is rarely great, but upon the same earnings the stock, followed by convertible bonds, may soar to high prices.
Either class injects an element of great uncertainty into the affairs of the corporation. This is particu larly so with the convertible bond, as the exercise of the conversion privilege makes possible radical and rapid changes in the capitalization of the company. Both of these privileges also tend to depress capital stock values, since they may eat into profits which would otherwise go to stockholders in dividends.
4. Redeemable bonds.—A redeemable bond is one which may be paid by the corporation before maturity. If the date of payment is optional with the corpora tion, it is sometimes called an optional bond, or a callable bond. Since the fluctuation in bond prices is not very broad or rapid, speculation in securities is confined mainly to the stock market. The bond market is therefore less active and it is sustained largely by the demands of permanent investors, who desire the greater safety and more steady income of bonds, rather than the risks and uncertain income of stocks. Any element in the bond, therefore, which lends uncertainty to the date of payment, with conse quent inconvenience and perhaps loss of interest to the investor while changing investments, detracts from its market value.