VII

MUNIc.i.p.aL BONDS

The previous chapters have considered, in turn, the investment value of railroad bonds, real-estate mortgages, industrial bonds, and public-utility bonds. The desirability of each of these different cla.s.ses of security has been judged in accordance with the general principles laid down in the introductory chapter; that is to say, each cla.s.s has been a.n.a.lyzed in relation to safety, rate of income, convertibility, prospect of appreciation in value and stability of market price. The same determining factors must now be applied to a judgment of government, State, and munic.i.p.al bonds.

Bonds issued by a national government, by a State, or by a munic.i.p.ality are based primarily on some form of the power of taxation, tho the bonds are usually tax exempt within the political unit which creates them.

When the power of taxation is unlimited, as in the case of the national government and the sovereign States, there can be no question as to the ability of the political unit to meet its obligation, and the question becomes entirely one of good faith. It is probable that the obligations of the United States Government, by reason of the fact that the per-capita debt of the country is so small, the wealth of the country so great, and the good faith of the American people so clearly established, represent the highest type of security to be found in the world. It is quite possible, therefore, that the 2-per-cent United States Consols would sell in any case at a relatively higher price than the obligations of any other country, but it can not be denied that the chief reason which causes them to sell at the remarkably high price which they have attained is the fact that they are required by national banks as security for circulation. This fact is doubtless the controlling element in their market position, and at once accounts for their special strength and removes them from the field of private investment.

Only less secure than United States bonds are the obligations of the sovereign States of the Union. State bonds usually sell upon a basis which may be taken as the equivalent of pure interest, with no element of risk or speculation involved. The obligations of different States sell at different prices, in accordance with market conditions and the relations of supply and demand, but there can be no question of the equal ability of all States to pay their obligations. Repudiation of State debts has occurred in our history, but only in cases where an overwhelming majority of the citizens were opposed to the creation of the debt at the time of its issue, but lacked the means to control the situation. Such instances are chiefly to be found in the case of the so-called carpet-bag governments of the Southern States after the Civil War.

Munic.i.p.al bonds--_i.e._, the bonds of cities, counties, and townships--are indirectly a first lien upon all taxable property in the munic.i.p.ality, and take precedence of every form of mortgage or judgment lien. This lien is enforced through a tax levy to meet interest and princ.i.p.al, and this tax levy the courts will compel in the rare cases in which a munic.i.p.ality attempts to repudiate a valid bond. This priority of the tax lien is the foundation of the prime position of munic.i.p.al bonds. The case rarely occurs where a bond held valid by the courts proves uncollectable if sufficient taxing power existed when the bond was issued to provide for its redemption. It is only when the munic.i.p.ality itself diminishes in population and taxable property to the vanishing-point that such a default can occur. An investor can judge for himself as to the likelihood of such a catastrophe in any particular community, and can feel sure that his bond, if valid and protected by a sufficient taxing power, is as secure in its princ.i.p.al and interest as the munic.i.p.ality which issues it is secure in its continued existence.

The following are the chief points which should be considered in the investigation of a munic.i.p.al bond: (1) The proportion which the total debt of the munic.i.p.ality bears to the a.s.sessed valuation of the property subject to taxation. Usually a maximum rate is fixt by const.i.tutional provision which rarely exceeds 10 per cent. (2) The purpose of issue.

This must be a proper and suitable one. (3) The proceedings under which the bonds were issued. These proceedings, the form of bonds, their execution, and their legal details must be in full compliance with the law.

If these points are found to be satisfactory, the investor may rest content that no other form of security is so greatly safeguarded and that his bond ranks upon a substantial equality with government and State obligations.

The rate of income to be derived from investment in munic.i.p.al bonds varies in accordance with the obligations selected. Like other forms of security, munic.i.p.al bonds are controlled by market conditions, and their price is determined by the relations of supply and demand, and by adjustment to prevailing money rates. While differing only moderately from one another in point of safety and income return, munic.i.p.al bonds may be divided into two distinct cla.s.ses in accordance with the degree of convertibility which they possess. Some munic.i.p.al bonds possess great convertibility; others almost none. The feature which chiefly determines the activity or inactivity of a munic.i.p.al issue is the size and importance of the munic.i.p.ality, together with the amount of bonds which it has outstanding. The bonds of large and important cities, whose outstanding debt reaches considerable proportions, usually possess great activity. They are constantly traded in and command a broad market because dealers are willing to buy or sell them in blocks at prices within a fraction of 1 per cent apart.

On the other hand, the bonds of counties, townships, and small cities are usually quite inactive. Transactions rarely occur in them, dealers do not make a market in them, and they can be sold only to genuine investors. It is often impossible to have them even quoted.

At first sight, it would appear that active munic.i.p.al bonds would be much more desirable, but inactive munic.i.p.als possess a special advantage which the active ones do not enjoy. They possess more stability of market price. It is true that their stability of value is due to the fact that they are not traded in or quoted and is, therefore, largely fict.i.tious, but nevertheless it accomplished a useful purpose. It enables the investor to carry inactive munic.i.p.als at cost price upon his books through periods in which active market bonds would require to be marked down in conformity with prevailing market prices. No other cla.s.s of investment except real-estate mortgages possesses to the same degree this quality of price stability. For many cla.s.ses of buyers--savings-banks, for example--stability of price is a consideration of prime importance. The preservation of the savings-bank's surplus and, indeed, the continued solvency of the inst.i.tution depend upon maintaining the integrity of the princ.i.p.al which it has invested. A savings-bank requires, also, great safety of princ.i.p.al and interest; _i.e._, the certainty that princ.i.p.al and interest instalments will be paid at maturity. It needs only a fair but not high yield, and it does not need to place emphasis upon convertibility or prospect of appreciation in value. Comparison of these requirements with the characteristics of inactive munic.i.p.al bonds discloses a striking adaptability on their part to the real needs of the case. As a consequence, it is not surprizing to discover that inactive munic.i.p.als are greatly sought by savings-banks.

The desirability of inactive munic.i.p.als for savings-bank investment was never more forcibly ill.u.s.trated than on the first of last January, when the savings-banks came to make up their annual statements. Broadly speaking, there can be no doubt that they were saved by the large quant.i.ty of inactive munic.i.p.als and real-estate mortgages which they carried. Had any considerable portion of their a.s.sets consisted of railroad bonds and active munic.i.p.als, upon which they should have had to write off a loss of ten to fifteen points, their solvency would almost certainly have been impaired.

But we are chiefly concerned in these pages with the advantages and disadvantages of different forms of investment from the point of view of a business man, both for the investment of his business surplus and of his private funds. Do munic.i.p.al bonds, either active or inactive, conform to the requirements of the business surplus? It can not be said that they do. Munic.i.p.al bonds possess either convertibility without stability of price or stability of price without convertibility. Both qualities are necessary for a business surplus. The only form of munic.i.p.al security which is at all adapted for the investment of a business surplus is a short-term issue of an active munic.i.p.al bond. If it has only a very few years to run, its constant approach to maturity will invest it with the necessary stability of price. But even in this case equal safety and equal stability of price combined with a higher yield can probably be found in some high-grade railroad issue--either a short-term mortgage or equipment bond.

For private investment the case is somewhat different. Enough has been said in the preceding chapters to impress upon the reader the importance of buying securities only in accordance with his real requirements. If any investor, after careful comparison of the characteristics of munic.i.p.al bonds, either active or inactive, with his necessities, decides that he can more closely satisfy his requirements with munic.i.p.als than with any other form of security, he should not hesitate to purchase them. It is the opinion of the writer, however, that a thorough survey of the field of investment will generally disclose to the investor some security in either the railroad or corporation field which will suit his requirements as well as the munic.i.p.al bond and at the same time provide him with a greater income.

VIII

STOCKS

Pa.s.sing to the consideration of stocks as investments, it is necessary at the outset that the reader should have clearly in mind the fundamental difference between stocks and bonds. This distinction was drawn in the introductory chapter, but it will be well to amplify it here, even at the risk of carrying the reader over familiar ground.

The distinction between bonds and stocks is that between _promises to pay_ and _equities_. Bonds, loans on collateral, and real-estate mortgages represent some one's promise to pay a sum of money at a future date; and if the promise be valid and the security ample, the holder of the promise will be paid the money on the date due. Stocks, on the other hand, represent only a beneficial interest or residuary share in the a.s.sets and profits of a working concern after payment of its obligations and fixt charges. The value of the residuary share may be large or small, may increase or diminish, but in no case can the holder of such a share require any one, least of all the company itself, to take his share off his hands at the price he paid for it, or, indeed, at any price. If a man buys a $1,000 railroad bond, he knows that the railroad, if solvent, will pay him $1,000 in cash when the bond matures, but if he buys a share of railroad stock his only chance of getting his money back, if he should wish it, is that some one else will want to buy his share from him at the price he paid for it or more. If he buys a bond he becomes a creditor of the company, without voice in its management, but ent.i.tled to receive his princ.i.p.al and interest when due under pain of forfeiture of the security which the company made over to the trustee to insure payment. If he buys stock, he becomes a partner in a business enterprise, exercising his proportionate share in the direction of the company's affairs, and sharing ratably in its profits and losses. In the one case he buys a promise to pay and in the other an equity.

This distinction, which appears plainly marked in theory, has been much obscured in recent years by the influence of two factors. As the country grew in size, the large corporations--the railroads, for example--required greater capital in order to provide facilities for the handling of their growing business. It was impossible to provide this capital wholly by means of bond issues without destroying the proportion between bonds and stocks, which alone could give to the bondholders the protection of a substantial equity. It was therefore necessary to obtain a large part of the capital required in the form of stock. The railway-managers were thus confronted with a difficult problem. It was imperative that they should obtain more capital, and it was impossible to dispose of sufficient stock on the basis of a speculative risk in a business venture. It was therefore necessary for the railway-managers to emphasize, as far as possible, the investment character of their stock, and various expedients were adopted to accomplish this purpose. In some cases preferred stocks were created or resulted from reorganizations, which possest a first lien upon the a.s.sets after payment of the obligations, and which were ent.i.tled to a certain stipulated dividend before the common stock obtained any distribution from the earnings. In this way the railway-managers created a compromise security which could be regarded as a stock, and would thus provide equity from the bondholders' point of view, and, at the same time, one which could be disposed of to investors. In other cases, which were probably more numerous, railway-managers attempted to give their stock an investment value through stability of income return. In good years when the company earned 10 or 15 per cent on its stock, their policy was to pay only 5 or 6 per cent in dividends, and hold the rest in their surplus fund in order to have the means of paying the same dividends the next year if only 2 or 3 per cent should be earned. By giving their stock stability of income return they hoped and expected to give it some stability of market price, and thus make it attractive to genuine investors. The effect of this policy was unquestionably successful, and one after another the stocks of our more important transportation systems and other large undertakings pa.s.sed into the hands of investors.

The successful adoption of this policy on the part of the railway-managers and other captains of industry has had one curious effect which was not contemplated by the originators of the movement, and which brings us to the second influence mentioned above as having tended to obscure the distinction between bonds and stocks. When a case has been brought before the courts in which the contention was advanced that the charges of the railway or public-service corporation were too high, the courts appear to have taken the ground that stocks and bonds should be cla.s.sed together in order to determine the aggregate capitalization of the company, and that the justice or injustice of the contention that the charges are too high should be determined by ascertaining whether if the charges were made lower the net earnings would still be sufficient to pay a fair return on the total capital invested. This is the general line of reasoning pursued by the courts, both in the case of the Consolidated Gas Company in New York and the Pennsylvania Railroad in Pennsylvania. The effect of this att.i.tude on the part of the courts has been to obscure still more greatly the real distinction between bonds and stocks. It is too early as yet to judge what will be the final outcome of the changed att.i.tude toward stocks, but it can not be doubted that the present tendency of opinion on the subject, so far as large corporations are concerned, is to limit the return on stocks to a strictly investment basis, instead of leaving the stockholders free to reap all possible profit from their business venture subject to the restraints of compet.i.tion.

The adoption of this att.i.tude by the courts should be a matter for serious consideration on the part of present and prospective stockholders. If the maximum return on stock is to be limited to 6 per cent, or any fair investment basis, and charges reduced to consumers so that they obtain the benefit of any greater earning power, it would appear that the stockholders occupy an undesirable position. With their possible profits limited, but with no fixt return insured to them and no guaranty against possible loss, it can not be held that the purchase of stock seems attractive.

These questions, however, will doubtless be settled in the long run in justice both to the public and to the stockholders, and in the meantime the stocks of our large and successful railway and industrial corporations, which have attained a certain stability and permanence of value, are ent.i.tled to consideration when investments are contemplated.

It is not worth while to lay down rules for judging the investment value of such stocks, because the general principles advanced in the preceding chapters will be found sufficient for a judgment of their values.

One cla.s.s of stocks, however, deserves special mention. Bank and trust-company stocks possess one characteristic in higher degree than other cla.s.ses of stock. Owing to the general practise of self-regulated banking inst.i.tutions to distribute only about one-half their earnings in dividends and to credit the rest to surplus account, a steady rise is a.s.sured in the book value of the stock. No other cla.s.s of stock possesses quite the same promise of appreciation in value. Bank and trust-company stocks are especially sought by wealthy men, who can forego something in the way of income return for the sake of increasing the amount of their princ.i.p.al. The general characteristics of bank stocks are great safety, a low rate of income, limited convertibility, and practical certainty of appreciation in value.

With the present chapter the discussion of specific forms of investments has come to an end. The next and concluding chapter will explain the general principles which control the market movements of all negotiable securities, and will endeavor to point out the indications which may be relied upon in determining whether or not given conditions are favorable for the purchase of securities.

IX

MARKET MOVEMENTS OF SECURITIES

There is no question connected with the investment of money more important than the ability to judge whether general market conditions are favorable for the purchase of securities.

After learning how to judge the value of every form of investment, a man may still be unsuccessful in the investment of money unless he acquires also a firm grasp upon the general principles which control the price movements of securities. By this it is not meant that a man needs to have an intimate knowledge of technical market conditions whereby to estimate temporary fluctations of minor importance, but rather that he should have clearly in mind the causes which operate to produce the larger swings of prices. If an investor acquires such a knowledge, he is enabled to take advantage of large price movements in such a way as materially to increase his income, and, at the same time, avoid carrying upon his books securities which may have cost much more than their current market quotations. If he can recognize the indications which point to the beginning of a p.r.o.nounced upward swing in securities, and if he can equally recognize the signs which indicate that the movement has culminated, he can liquidate the securities which he bought at the inception of the rise or transfer them to some short-term issues whose near approach to maturity will render them stable in price, allowing the downward swing to proceed without disturbing him. It is not expected, of course, that the average business man will be able to realize completely this ideal of investment, but it is hoped that the following a.n.a.lysis will give him a clearer conception of the principles involved.

Broadly speaking, the market movements of all negotiable securities are controlled by two influences, sometimes acting in opposition to each other and sometimes in concert. One of these influences is the loaning rate of free capital; the other is the general condition of business. A low rate of interest or the likelihood of low rates has the effect of stimulating security prices, because banks and other money-lending inst.i.tutions are forced into the investment market when they can not loan money to advantage. Conversely, a high rate of interest or the prospect of high rates has the effect of depressing prices, because banking inst.i.tutions sell their securities in order to lend the money so released. The automatic working of this process tends to produce a constant adjustment between the yields upon free and invested capital.

When money rates are low, securities tend to advance to the point where the return upon them is no greater than that derived from the loaning of free capital. When rates are high, securities tend to decline to a point where the return is as great. This explains the influence of the first factor.

The other factor is the general condition of business. Good business conditions, or the promise of good conditions, tend to advance security prices, because they indicate larger earnings and a stronger financial condition. Poor business conditions, or an unpromising outlook, have the reverse effect.

The larger movements of security prices are always the resultant of the interaction of these two forces. When they work together the effect is irresistible, as when low interest rates and the prospect of good business conditions occur together, or when high money rates occur in the face of an indicated falling off in business activity. At such times all cla.s.ses of securities swing together. For the most part, however, money rates and business conditions are opposed in their influence, rates being low when business is bad and high when business is good.

Usually the worse business conditions become, the easier money grows; while the more active business becomes, the higher money rates rise. The effect of this antagonism between the controlling causes is to produce movements of different proportions and sometimes in different directions in different cla.s.ses of securities. High-grade bonds may be declining, middle-grade bonds remaining stationary, and poor bonds advancing, all at the same time. This serves to give a very irregular appearance to the security markets, and appears to justify the widely held opinion that security prices are a pure matter of guesswork, and that they are controlled only by manipulation and special influences. A clear conception of the nature of the influences which are always silently at work reconciles these apparent inconsistencies and makes it plain that general price movements are determined by laws as certain in their operation as the laws of nature.

This may be ill.u.s.trated by a single example. Let us a.s.sume that interest rates are low and business conditions bad with prospect of still lower interest rates and still more unpromising business conditions. What will be the effect upon different cla.s.ses of securities? High-grade bonds, such as choice munic.i.p.als, whose safety can not be impaired by any extent of depression in business, will advance because their market price is influenced almost wholly by money rates. If their interest is certain to be paid, no matter what business conditions may become, they can not be greatly affected by a reduction of earnings, and consequently the influence of low money rates is left to act practically alone.

Middle-grade bonds, such as second-cla.s.s railroad issues, will remain almost stationary, low money rates tending to advance their price and the fear of decreased earnings tending to depress them. The lowest grade of bonds and stocks, whose margin of security even in good times is not very great, will probably suffer in price because the fear of default in interest and of reduction in dividends will operate much more strongly than the mere stimulus of low interest rates. Of course, securities can not be clearly separated into these three cla.s.ses, but shade imperceptibly into one another. The cla.s.sification is adopted only for purposes of ill.u.s.tration.

Up to this point we have been concerned merely in showing that the market movements of negotiable securities are controlled by the influence of certain factors. A more important question now remains to be considered, viz.: whether the effect of these two influences is to produce general swings in prices which may be depended upon with comparative certainty, and, if so, what indications are afforded to the investor of the commencement or culmination of such a movement. The answer must be that the combined effect of the two influences described is to produce definite and regular swings in prices, and that the indications which define the movements are not difficult to follow.

A general survey of the history of every industrial nation reveals the fact that business conditions undergo alternate periods of prosperity and depression extending in clearly defined cycles of substantially uniform length. By tracing the usual course of interest rates and of business conditions throughout one of these cycles, a general idea can be formed of the way in which the joint influences operate to produce price movements. To what extent the course of interest rates is a cause as well as a result of changing business conditions, we shall not attempt here to estimate, but will be content to note carefully the general course which rates for money pursue throughout the cycles.

Immediately after a financial crisis, which usually closes an era of great business prosperity, money rates become abnormally easy. Within a few months from the climax of the crisis, money acc.u.mulates in enormous volume in financial centers. This is caused by the great diminution of business activity which renders unnecessary a large part of the circulating medium that was formerly required to transact the greater volume of business. To the extent to which this acc.u.mulation of money merely reflects a redundancy of currency as distinguished from real liquid capital, it can have little effect in encouraging the resumption of business activity. As time pa.s.ses, however, and economies in operation commence to make themselves manifest, and especially as waste and extravagance are curtailed, the country as a whole commences to acc.u.mulate real liquid capital; that is to say, its total production leaves a surplus over the amount of consumption. In the state of business feeling which has been pictured, the undertaking of new business ventures or additions to existing properties would not be approved, so that the surplus wealth created finds its way into bank deposits as liquid capital. The compet.i.tive attempt to loan this capital at a time when borrowers are few produces merely nominal interest rates.

This continues for some time. It is only gradually as confidence returns and as the spirit of initiative begins to rea.s.sert itself that some part of the liquid capital created each year is diverted into fixt forms.

Here and there some enterprising group of men will develop a mine, lay a new piece of railway, or make some addition to an existing undertaking.

For some length of time, however, the liquid capital of the country not only remains unimpaired, but is continually increasing. After a time a change comes. The annual surplus of production, tho larger than before, is only sufficient to provide for the new undertakings which the growing optimism demands. Interest rates rise moderately in response to the added demand for capital. A few years further along, as business activity increases and success appears plainly to wait upon new ventures, the demand for new capital with which to develop increased facilities and new enterprises exceeds the annual supply of wealth created. Prosperity having increased, another factor commences to a.s.sert itself. The spirit of economy and thrift which had prevailed throughout the years of depression gives place to extravagance, the demand for luxuries, and other unproductive forms of expenditure. While the total production is much greater than in the lean years, the margin of production is not proportionately as great, and this amount is insufficient to meet the demands upon it. The supplies of liquid capital stored up during the years of depression are resorted to, and they serve to provide the new capital for a few additional years. Interest rates at once reflect the encroachment upon stored-up capital, and their rise gives the first real warning of the country's true position. The optimistic business men do not heed the warning. After exhausting all the real capital available in the country, they proceed to borrow extensively from foreigners or from government banks--in this country from the national government through bank deposits. Every step which can be taken to induce foreigners to part with their capital is resorted to.

If foreigners will not buy long-term bonds, short-term notes are created. If the foreigners refuse these, they are asked to make loans secured by the new bonds and notes. The rates of interest offered are so attractive that considerable sums are usually obtained, and the pressure of business activity continues further. Finally the day of reckoning arrives when some incident, usually unimportant in itself, first suggests to the lenders of money that their debtors whom they know to be overextended may not be able to pay their loans. The attempt to collect their loans produces a financial crisis which brings to an end the period of prosperity.

The foregoing is a description of the more important stages through which business conditions pa.s.s from crisis to crisis. Different cycles vary in particular details, but all agree in essential outlines.

Sometimes special influences are at work which operate to shorten or prolong the cycle. The approach of a crisis will be r.e.t.a.r.ded by inflation of the currency, for the excess finds its way into bank vaults and increases the volume of loanable credit. The effect of such inflation, however, is wholly disastrous, because the addition to the supply of capital is fict.i.tious, not real, and only defers the day of reckoning for a greater catastrophe. On the other hand, the approach of a crisis can be greatly hastened by wars, conflagrations, and other agencies which destroy capital, and by attacks upon capital and the conduct of corporate business, for such attacks tend to render capital timid and produce the same effect as a violent curtailment of the supply. These are only some of the many influences which might become operative, but they serve to show the necessity for careful consideration of all the factors at work if a true conception of the condition and tendencies of business is to be formed.

From the general account given above of the successive phases of a credit cycle, it is possible to summarize the course of interest rates and the course of business conditions. Money rates become suddenly easy after a crisis, remain low or grow easier for a period of several years, and then rise continuously until the next crisis, advancing with great rapidity toward the close of the cycle. Business conditions remain poor or grow worse a few years after a crisis. Liquidation is taking place, prices are going down, and the uncertainty of the outlook causes diminished activity. Thereafter, however, conditions improve and activity increases with fair uniformity until it reaches the high tension of the period immediately preceding the crisis. The course of interest rates and the course of business conditions may both be deflected by the operation of special influences, but the general tendencies are substantially as outlined. The result of the operation of these joint factors may be traced in the market movements of any cla.s.s of security desired. For the sake of simplicity, let us consider their effect in producing the market swings of the highest grade of investment issues and of the lowest grade, those which are affected only by money rates and those which are affected almost wholly by business conditions.

Emerging from the strain of the crisis at their lowest point, high-grade bonds, such as the best munic.i.p.al and railroad issues, advance rapidly as interest rates decline, continuing their advancing tendency throughout the period of business depression which follows upon the heels of the crisis. As business conditions improve, their position, while perfectly secure before, is further strengthened and an added stimulus is given to their rise. About the middle of the cycle when the business outlook is very promising, and before interest rates have sustained any material advance, the prices of high-grade bonds are usually at their highest point. From that time forward they commence to decline, in spite of the increasing prosperity of the country, under the influence of rising money rates. They make their lowest prices in the midst of the crisis, when the strain upon capital is greatest and the outlook for business most unpromising.

The lowest grade of bonds, on the other hand (whose margin of security is least), do not commence to recover materially in price, in spite of the influence of low money rates during the hard times which follow the crisis, the influence of reduced earnings and the fear of default of interest holding them in check. As the outlook becomes brighter, they advance rapidly and continue to improve in price so long as they yield more than current money rates. At some point, difficult to determine in advance but usually well along toward the end of the cycle, they reach their high point and thereafter decline under the influence of the growing stringency in money.