This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Most purchasers of the bonds of high grade companies are primarily interested in the safety of their principal plus a moderate rate of return. Most purchasers of shares, on the other hand, are primarily interested in securing profits due to the enhancement of the value of their holdings, plus as high a rate of return as they can secure. If they purchase stock with their eyes open, they realize that they are voluntarily incurring more or less risk. Between these two main bodies of purchasers of corporate securities, there are a great many investors who wish to secure reasonable safety combined with a reasonable chance for appreciation in the value of their holdings. Preferred shares are intended in part to meet the wishes of this intermediate class. Convertible and participating bonds are designed also to appeal to this group.
The adjective "convertible" in itself has no definite meaning. The bonds may be convertible into anything on any terms. Ordinarily, however, the convertible feature gives to bondholders the privilege of exchanging their bonds within certain time limits and at a rate fixed in advance, for the corporation's common shares. The bondholder may reason that he secures under this arrangement a sound and safe security which yields a moderate rate of return and in addition has a chance of speculative profits due to the possible enhancement in the value of the company's shares. Thus, the Union Pacific Railroad Company's issue in 1901, of $100,000,000 of 4% bonds, which were convertible into common stock at par before the expiration of this conversion privilege, sold considerably higher than par. Practically all of this issue was converted and its holders obtained a sizable profit. It has not been unknown for original purchasers of these securities to obtain profits in this manner running as high as 25 to 50%; this is in addition to the normal rate of interest on their investment.
There is, of course, the corresponding drawback that the conversion privilege, if it is really valuable, increases the selling price of the bonds and this lowers slightly the yield on the investor's capital. However, in view of the fact that the large buyers of bond issues are institutions which are not attracted by the possibility of speculative profits, it has been found that those who were willing to purchase the convertible bonds of good companies are frequently able to get them at a very reasonable price. There are, of course, all shades of variations in the attractiveness of convertible bonds. The Pennsylvania Railroad Company has put out some issues which are convertible into common stock at such a high rate of exchange that there seems to be no probability that the conversion privilege will become valuable.
From the corporation's point of view there are obvious objections. It may well be argued that the company is taking the chances. If its business moves along successfully and its stock increases in value, the holders of convertible bonds share in the prosperity without having shared in the preliminary risks. On the other hand, in case some unforeseen misfortune reduces the company's earnings, the convertible bondholder naturally enforces his claim with the same rigor as any other creditor. As a matter of fact, convertible bonds are seldom issued except in periods when the demand for capital is large and when it is necessary for corporations - even those in highest standing - to make concessions. In the United States, these securities were first issued during and after the Civil War. The financing of the Chicago, Milwaukee and St. Paul Railroad Company from 1860 to 1880 was chiefly effected through issues of convertible bonds, and it is stated that as late as 1896 there were twelve separate convertible issues of this company outstanding. From 1880 to 1900, on the other hand, the practice was discontinued and was generally thought to have become obsolete. Since 1900 there has been a revival of convertible issues, which is to be explained chiefly on the ground of increased demand for capital.
Among the convertible bonds now outstanding may be mentioned:
Atchison 4's, due 1955, which were convertible up to June 1, 1913, into common stock at 100.
Union Pacific Debenture 4's due 1927, convertible prior to July 1, 1917, into common stock at 175.
American Telegraph and Telephone Company's debenture 4's, convertible up to March 1, 1918, into stock at 133.7374.
Participating bonds attempt to offer a like advantage by giving to the bondholders a right to share in excess profits after all the obligations of the company have been provided for. They are like income bonds except that it is obligatory on the part of the company to pay the fixed rate of interest, and the participating feature applies only to excess payments. The best known issue of this kind was the "Oregon Short Line Cumulative Trust Participating 4's" issued in 1903 but almost immediately retired, which were to receive 4% interest plus whatever dividends in excess of this amount were declared upon the stock of the Northern Securities Company, deposited as collateral.
An English issue of the same type consists of the profit-sharing debentures of the Anglo-Netherlands Sugar Corporation, which bear interest at 5% and in addition are entitled to 25% of the surplus net profits remaining after the sinking fund has been provided for and after 5% has been paid on ordinary shares, "such participation, however, being limited to an additional 21/2 %" In other words, these debentures cannot under any conditions pay more than 7 1/2%. Participating and profit-sharing bonds have not proved especially popular either in the United States or in England.