Hedging a Rising Interest Rate

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

by HOWARD DOUGLAS DOZIER

MONEY income is bought and sold in the market in units of ’dollars per year.’ An income buyer, or investor, may purchase a short or a long segment of a continuous income, but it will still be expressed in this unit. The price paid for income, like the price paid for goods and services, is said to be high when few units of it can be bought per dollar.

At the present time the price of money income is unprecedentedly high. Less than $3.00 per year of United States Government income can be had to the $100. Only $4.00 to $4.50 of good corporate income per year can be obtained to the $100 of investment in high-grade corporate bonds.

Now high altitudes in the price of money income, as is the case in other economic sectors, create elements ot danger to those who pay them. One can fall off the doorstep with much less chance of injury than he can off the roof. When raw materials and inventories are selling at unusually high prices, purchasers protect themselves by buying often and little, and by so doing escape the risk of converting any great amount of materials already paid for at a high price into finished products salable at possibly lower prices but remaining yet to be sold at any price. Those who sell raw materials and inventory stock may not like to do business in this fashion, but if they must choose between this kind and the doing of none at all they grin and endure and eventually accommodate themselves to the conditions.

This situation has its counterpart presently in the money market. The investing public does not now relish the idea of tying its hands by a contract to pay the prevailing high prices of income for a tiny stream to continue for any considerable period of time. It figures that high prices for anything fall sooner or later, and that the price of money income is no exception to the general rule. The price of money income for the first year or so of a fifteen-year segment may be predictable, but the latter portion of the segment is as crooked as a question mark. Income buyers do not like to contract for high-priced income for a too-far-away future delivery. If they do purchase it for delivery so far in advance that they can tell nothing about its price at the date of delivery, they demand special inducements.

The sellers of income in the form of interest on bonds are satisfied, of course, to sell as little of it per year for as much as possible, and to continue for as long a period as possible. This is cheap capital to them. But they are now beginning to find it necessary to respect the wariness of prospective income buyers.

It is the purpose of this paper to analyze two varieties of financial make-up now being used to stimulate investor desire. The base of all these is generally the debenture bond, a plain note of hand secured by the general credit of a corporation, but not by a mortgage on any of its property. For the purpose of illustration I shall assume a 5 per cent fifteen-year debenture issued on the same day as this month’s Atlantic. The purchaser pays $1000 for a $50-a-year income continuing for fifteen years. At the expiration of this period, but not before, the corporation obligates itself to repurchase this income from the holder at its original sale price — namely, $1000. From the standpoint of the corporation this means simply that it pays off its bonds when due and kills off the interest it has been paying on them.

This is all very well for the corporation, — too good, in fact, — but fancy, if you will, the state of mind of the income buyer, and his regret, if, at the end of the fifth year of the stretch of fifteen, the price of income had so fallen that he could buy a $100-a-year income with his $1000. It is to avoid such an investment predicament that the public, during periods of extremely high prices for money income, demands a future exit.

In order to fit their offerings to the existing state of the investment mind, some corporations have begun to offer for sale debentures convertible into common stock and debentures with commonstock purchase warrants attached.

Let me take the straight debenture and graft onto it the convertible privilege, showing at the same time the effect on the investor and that on the corporation which sold it. We may assume that investment sentiment is so suspicious, because of the high price at which income is selling, that in order to put out a 5 per cent fifteen-year debenture at par the issuing company, whose common stock is paying no dividends and is selling at $25, finds it necessary to make these debentures convertible into common stock. It therefore includes in the contract a paragraph giving the purchaser or subsequent owner the right to surrender his $1000 debenture and receive in return common stock at $50 per share, or as many shares as there are $50’s in $1000 — that is, twenty shares. So long, of course, as the stock pays no dividends and sells at less than $50 a share in the open market, the conversion privilege will not be exercised. To exercise it at such a time would be exchanging some income, though small, for none.

Depression does not last forever; corporate profits and dividends do not remain nil for all time. Should the affairs of the issuer of these convertible debentures recover to the point where its earnings would justify the payment of a $6.00 dividend, and should the directors declare one of this amount, the owner of a debenture would be faced with the question of whether to sell to the company a $50-a-year income of one kind and buy from it, with the funds thus received, a $120 one of another kind. If he should retain his debenture he would remain a creditor, receive his $50-a-year income for the remaining segment of the fifteen years, and then sell it back to the company for $1000. If he should convert it he would become an owner, assume the risk of management, and take his chances of continuing to receive his $120-dividend income, neither the company nor anybody else being under obligation to purchase or repurchase at any price. A corporation’s prosperity means enhancement in the price of its common stock, and it may rise to above $100. By the same token, enhancement takes place in the price of its debentures, which are linked to its common stock by the conversion privilege. Whether the debenture holder converts or not, he escapes the dangers inherent in the high price originally paid for debenture income.

From the standpoint of the corporation, conversion under the conditions set forth above transforms a $50 outgo into a $120 one, but the $50 payment could be avoided only by a breach of contract, whereas after conversion the $120 outgo can be terminated merely by a vote of the board of directors. Since conversion substitutes a contingent payment for a fixed charge, it gives the corporation potential prospective relief. While the process of conversion brings no new money into the company for capital expenditures, at least it takes none out.

Now let us look at the second lure, the stockpurchase warrant attached to a debenture. The ordinary investor might be willing to buy a tiny three-year income at a high price if he had assurance that he could sell it back to its creator at the end of that period for original cost. Buying on such terms for a fifteen-year stretch is quite another matter, however. Much can happen in that time.

Here the corporation encounters sales resistance, and the inclusion in debenture contracts of a provision for the purchase of common stock is one method of meeting it. To each debenture sold there is physically attached a warrant which, with a given amount of money stated in the warrant, will pay for the number of shares indicated at the price named.

Let us suppose that there is attached to each $1000 debenture a warrant which states that the holder of the bond and its warrant is entitled to buy ten shares of the corporation’s stock at $60 per share at any time after the third anniversary of the issue of the debenture. This gives the buyer of debenture income at a high figure a chance to get additional income later at a lower price, if income prices fall, or a chance to share in the success of the corporation if it does unusually well. He has, however, to put up additional money if he is to buy stock of the company on the terms set forth. In the case of conversion the converter merely exchanges an income of one kind and amount for another of different kind and amount.

He who holds a debenture with stock-purchase warrants attached attains his ends a little differently. Whenever he clips the warrant he reduces himself to the status of a mere debenture holder, but by way of compensation he becomes a potential stockholder. When he becomes one in fact through the purchase of stock of the company, he really has two incomes — one bought at one price at the outset and another bought cheaper at a later date.

The exercise of the right to buy stock as set forth in the warrant has its effect upon the corporation, too. Its capitalization is increased by the amount of new money brought in by the stock sale, but its bonded debt is not. Bonded indebtedness now constitutes a smaller proportion of total capitalization than it did formerly. The new money presumably increased earnings and strengthened the position of the debenture holders, inasmuch as no increase in interest occurred.

During periods when income sells at as high prices as now prevail, and corporations have to adorn their bonds in order to float them, investors should be sure of the composition of the make-up. Collateral agreements such as the two analyzed in this paper should be thoroughly dissected and held up to the light in order that investors’ rights under them may be determined with the greatest possible precision.