Railroad companies and other large companies usually have the stocks and bonds of subsidiaries avail able for collateral. Even strong companies like the Pennsylvania Railroad, whose general credit is un questioned, follow the practice of depositing such col lateral behind their notes, for the purpose of improv ing their marketability. There is little or no differ ence in such cases between these notes and short-term bonds. Sometimes mortgages or leases are deposited with the trustee, when collateral in other forms is not available. The increasing popularity of short-term notes is due largely to the growing practice of placing definite lien security behind them. This is done to attract bond investors, who are accustomed to specific security, and who are not willing to loan on general credit because of the difficulty or impossibility of ob taining and analyzing a correct statement of the com pany's affairs.
When corporate notes are not reinforced, their value rests upon the general credit of the company, which depends in turn mainly upon the surplus earn ings above fixed charges. When these notes mature, whether secured or unsecured, they are expected to be paid and not renewed, because they are a temporary expedient, employed to bridge over a seasonal demand or a period in which bonds cannot be sold to advan tage. They are not expected, except temporarily, to take the place of permanent financing. Instances could be cited in which such notes have been refunded by new issues of the same kind. Such instances, how ever, do not illustrate the general practice, as the notes are usually retired out of the current receipts from seasonal business, or by the sale of bonds.
It is customary for corporations to announce the purpose for which such notes are sold. An element of great strength is added if the proceeds are to be in vested in the business in a productive capacity, so that the new liability is offset by proportionately increased productive assets, increasing the income more than enough to pay the interest upon the notes. Fre quently a series of notes will be marketed for the pur pose of cleaning up a variety of current obligations, making needed repairs, and replenishing the cash ac count of the corporation. In such a case, they are not looked upon as favorably as tho the proceeds were to be invested directly in the business to increase its out put or capacity.
It is plain that anything which increases the net earnings of the company improves the security behind the notes, whether collateral is pledged or not. This is particularly important when no specific collateral is pledged to secure the loan. It is a distinct sign of financial weakness when notes are issued to retire cur rent or other maturing obligations, the company at the same time not possessing enough liquid assets to secure adequately its notes with collateral. This
brings us to the next topic, the purposes for which such notes may properly be issued.
8. Purposes for which corporation notes may be sold.—Within recent years a number of large railway companies have been forced into receivership by the maturing of their notes at inopportune times. This suggests the danger of such short-term financing and also the principal purpose behind it.
Long-term notes are ordinarily used only to finance other maturing obligations or new capital expendi tures at a time when bonds cannot be advantageously sold. During 1914 and 1915, for instance, while bond prices were low and declining, many maturing cor porate obligations had to be met and, at the same time, new capital provided for increasing production caused by war orders and unusual business activity. Many millions of dollars worth of long-term notes were sold to provide necessary funds until the bond market should recover and render permanent financing pos sible upon a normal basis. These issues mature mainly between 1917 and 1920. In most cases, the normal profits of the business cannot be relied upon to repay them at maturity.
If these notes should happen to mature during a depression, when permanent financing is still impos sible and business dull, or during war while capital is scarce, no doubt many of the companies will be seri ously embarrassed to refund or pay them off. With the United States in the war such embarrassment ap pears very likely at the time this is written. If the notes are refunded at all during such conditions, it will be at higher rates of interest or with greatly increased security. A renewal of maturing notes is considered a sign of financial weakness and almost always reflects upon the credit of the company. For these reasons, only the strongest companies should enter upon the policy of temporary financing of this kind, if any other course lies open.
Let us illustrate the use of such notes. Ten se lected railroad bonds were sold in 1909 at an average price of 101.6, to yield 4.15 per cent on the investment. In other words, these roads could borrow on bonds in 1909 at 4.15 per cent interest.. In 1915, these same bonds were selling at 89, and yielding about five per cent to investors at that price. In other words, a thirty-year bond, based on these actual averages, would cost in interest 30 times .85 per cent, or 25.5 per cent more, during the life of the issue, if sold in 1915 than if sold in 1909.