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Call Provisions

In previous editions we had a fairly long discussion of this aspect of bond financing, because it involved a serious but little noticed injustice to the investor. In the typical case bonds were callable fairly soon after issuance, and at modest premiums—say 5%—above the issue price. This meant that during a period of wide fluctuations in the underlying interest rates the investor had to bear the full brunt of unfavorable changes and was deprived of all but a meager participation in favorable ones.

EXAMPLE: Our standard example has been the issue of American Gas & Electric 100-year 5% debentures, sold to the public at 101 in 1928. Four years later, under near-panic conditions, the price of these good bonds fell to 62½, yielding 8%. By 1946, in a great reversal, bonds of this type could be sold to yield only 3%, and the 5% issue should have been quoted at close to 160. But at that point the company took advantage of the call provision and redeemed the issue at a mere 106.

The call feature in these bond contracts was a thinly disguised instance of “heads I win, tails you lose.” At long last, the bond-buying institutions refused to accept this unfair arrangement; in recent years most long-term high-coupon issues have been protected against redemption for ten years or more after issuance. This still limits their possible price rise, but not inequitably.

In practical terms, we advise the investor in long-term issues to sacrifice a small amount of yield to obtain the assurance of noncallability—say for 20 or 25 years. Similarly, there is an advantage in buying a low-coupon bond* at a discount rather than a high-coupon bond selling at about par and callable in a few years. For the discount—e.g., of a 3½% bond at 63½%, yielding 7.85%—carries full protection against adverse call action.

Straight—i.e., Nonconvertible—Preferred Stocks

Certain general observations should be made here on the subject of preferred stocks. Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one. The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand, the typical preferred stock carries no share in the company’s profits beyond the fixed dividend rate. Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner).

These weaknesses in the legal position of preferred stocks tend to come to the fore recurrently in periods of depression. Only a small percentage of all preferred issues are so strongly entrenched as to maintain an unquestioned investment status through all vicissitudes. Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (At such times they may be well suited to the aggressive investor but too unconventional for the defensive investor.)

In other words, they should be bought on a bargain basis or not at all. We shall refer later to convertible and similarly privileged issues, which carry some special possibilities of profits. These are not ordinarily selected for a conservative portfolio.

Another peculiarity in the general position of preferred stocks deserves mention. They have a much better tax status for corporation buyers than for individual investors. Corporations pay income tax on only 15% of the income they receive in dividends, but on the full amount of their ordinary interest income. Since the 1972 corporate rate is 48%, this means that $100 received as preferred-stock dividends is taxed only $7.20, whereas $100 received as bond interest is taxed $48. On the other hand, individual investors pay exactly the same tax on preferred-stock investments as on bond interest, except for