Rate Op Interest

The rate of interest which a bond bears is one of the important factors in determining the price at which the bond will sell. Other things being equal, a bond bearing 5 per cent interest will sell at a higher figure than one bearing 4 per cent interest. The price of gilt-edge bonds is determined very largely by the interest rate of the bond. No speculative interest is attached to such a bond. The rate of the interest is fixed. The price that will be paid for such a bond, therefore, depends chiefly upon the prevailing rate of interest. There is no possibility of an increase in the income of ordinary bonds and. therefore the rate of interest becomes a fixed factor in determining the value of the bond.

The degree of marketability which a bond enjoys often determines its price as much as the interest rate. Two bonds bearing the same interest and exactly equal as regards all those things by which the value of a bond is judged, may sell at entirely different amounts, as determined by the marketability of the bond. The bond which can be turned into cash at any time quickly, brings the highest price. Under normal conditions no special concession need be made on such a bond in order to convert it into cash. In other cases the holder of a bond may be tied up a considerable length of time and unable to dispose of it when he desires. In estimating the purchase price for a bond, interest rate and marketability are the determining factors where the security is adequate.

Prevailing rates of interest fluctuate in the course of a year and over a period of years. I need not explain the causes of these changes but simply describe their effect upon security values. These variations in current interest rates make it possible to float an issue of bonds at such a rate of interest as to insure their sale at par during the course of their whole life. The interest rate on a bond is fixed and cannot fluctuate, but the principal may increase or decrease and thus accomplish the same thing. Therefore, when current rates of interest on like securities are higher than the rate of interest which a bond bears, the price of the bond declines so as to make the return from it approximate the current rate. On the other hand, if current rates of interest are lower than that of a bond, the bond is likely to sell above par and thus reduce its yield proportionally. The price of gilt-edge securities, therefore, fluctuates in response to the current rates of interest during the lifetime of the bond. Figure 2 shows the fluctuations of twenty 4 per cent railroad bonds over a period of years. The 4 's are the most substantial of the outstanding issues.

Length Of Time To Run

The final factor to consider in the value of a bond is the length of time it has to run. A thousand-dollar bond bearing 4 per cent interest, when purchased at par, yields 4 per cent on the investment. But if it is purchased at $1,100, the return is naturally less than 4 per cent. The purchase price, therefore, is as important a factor in determining the returns from a bond as the rate of interest which it bears. Furthermore, if the above bond purchased at $1,100 were to run for all time, the yield would be 4 per cent divided by $1,100 or 3.64 per cent. If, however, this bond was to run for one year only, the buyer would receive at maturity $1,000, the face value of the bond, and $40 interest. Since he paid $1,100 for the bond, he would lose $60 on the transaction.

If this bond should run for ninety-nine years, the purchaser would receive interest upon the bond which would much more than make up for the loss which he sustained in the first year. He would distribute equally over this entire period the loss which he would suffer were he to pay such a premium for a bond maturing in one year.

This condition is exactly reversed when bonds are purchased below par. If this thousand-dollar bond had been purchased for $900 running one year, the purchaser would receive at the end of the year $1,000 as the principal of the bond and $40 for interest. He would, therefore, gain $140 during the year. This sum would be a return of 15.5 per cent on his investment. The longer the bond has to run, the less would be the return on the investment and the nearer would the yield approach the 4 per cent interest which the bond bears.

Obviously, therefore, the bond of a solvent corporation will sell approximately at par as the time for its payment draws near. If a bond has been selling at a premium, it will tend downward toward par, while if it has been selling at a discount, it will tend to sell up toward par. The length of time which a bond has to run is therefore an important consideration in the purchase of all bonds which are not selling at par. The bond and interest tables sold on the market enable an investor to determine what the income yield is upon each bond for the length of time it has to run, the price it can be had for, and the fixed rate of interest.

Influence Of Gold Production

Gold is as much a commodity of commerce as an article of consumption or an investment security. It responds to the law of supply and demand. It becomes cheap when it is plentiful and dear when it is scarce.

Since gold is used as the standard of value, its influence upon the value of security prices is evident. As gold becomes more plentiful security prices decrease in value, because the purchasing power of the fixed income of bonds becomes constantly less. As gold becomes scarcer the opposite tendency sets in.

Investors should not be influenced too much by theoretical discussions of the increased production of gold and the prospect of its reducing the price of securities with fixed incomes. At the present time the only large gold-producing field in the world which shows a large annual increase is that of the Rand in South Africa. When one considers the increased need for gold which the advances in sciences and civilization call for, it seems likely that the influence of this factor on rising prices is about to become less rather than more. Certainly, unless new fields are discovered or new methods of production are used so as greatly to increase the output, the gold factor should not worry investors.

The Valuation Of Bonds. Test Questions

1. Why is the earning power of the issuer the most important point to be considered in the valuation of a bond?

2. What are some of the tests of earning power to be applied to a railroad bond? An office building bond? A public utility bond?

3. What factors should be considered in valuing the security back of a railroad bond?

4. Why is it important to know who is sponsor for a bond issue?

5. What relation does the rate of interest of a bond have to the investment value of the bond?

6. What effect does the length of life of a bond have upon the interest rates? The return?

7. What effect does the production of gold have upon bond values?