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Adjustment Bonds
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

Bonds usually issued in connection with corporate reorganizations but which sometimes are issued in an adjustment of several existing issues into one class to provide for a uniform interest rate, thus a form of the consolidated type of refunding issue.  Adjustment bonds are practically synonymous with INCOME BONDS in that interest is payable only if earned.  Failure to pay the stated rate of interest, when not earned as determined by the provisions of the indenture, does not constitute act of default.  Interest upon adjustment bonds or income bonds is a claim on earnings only after payment of interest on all prior fixed interest obligations.  Thus it is a claim upon earnings prior to stock issues only.

The adjustment bond is a flexible instrument.  As its name implies, it is a device used by reorganization managers to aid in the adjustment of a capital structure that is too large for a company's anticipated earnings.  In approving railroad reorganizations under Section 77 of the National Bankruptcy Act, the Interstate Commerce Commission generally approved the issuance of contingent interest-bearing obligations, designated as income bonds, usually with an interest rate of 4.5% and limited cumulative feature, against the substantial probability of earning power to cover income bond interest but whose regular annual continuance could not be counted upon in periods of recession or depression.  The term income bonds has been used in such modern reorganizations, in lieu of adjustment bonds to designate such contingent interest obligations.  To make the capitalization more flexible and to reduce fixed charges, the holders of junior fixed-interest obligations of reorganizing corporation are asked to accept in part, or perhaps in whole, adjustment bonds or income bonds on which the payment of interest is contingent upon earnings.  Their function, therefore, is the substitution of contingent charges for fixed charges.  If the reorganized company, under the new capital structure, is successful, interest will be paid on the contingent interest adjustment bonds or income bonds; and if the times-earned-fixed-and-contingent-charges ratio is substantial regularly, such adjustment bonds or income bonds may attain an investment rating.  For example, the Atchison, Topeka & Santa Fe Adjustment 4s of 1995, originally issued in 1895, now command an investment rating.

Adjustment or income bonds as basically part of the bonded debt provide a tax advantage for the issuing corporation as compared with the new stock issued for old debt, in view of the tax deductibility of interest.  Yet in the event of insufficiency of current earnings to pay contingent interest, the company would not be embarrassed by default as in the case of fixed interest obligations.  Moreover, as debt securities, adjustment or income bonds provide leverage for the stocks.  Adjustment or income bonds may be more than mere debentures if they are secured by a mortgage, in which case they are secured debt obligations, albeit usually with a junior lien as to assets pledged.

An important feature to note in connection with adjustment bonds or income bonds is the nature of the contingent interest claim:  if earned, the interest is mandatorily payable; if not earned, the interest is fully cumulative, limited cumulative, or noncumulative.

Graham and Dodd in their Security Analysis (4th ed.), the standard in this field, suggest an analytical adjustment in computing the times-fixed-and-contingent-charges-earned ration which will reflect the contingent nature of the interest claim as well as the mandatory or discretionaly payment by directors:  if interest is mandatory if earned, it is suggested that the coupon rate be stepped up by 30% and calculation of the coverage ratio be made by the overall (cumulative deductions) method, before applying the "before tax" standards for fixed-interest bonds of investment grade; if the interest is discretionary, that the step-up factor be 50%.  Such an adjustment would give weight to the difference in interest claim and make comparable the application of investment grade standards, although the precise weighting is open to question.

Another structural feature of income bonds that should be noted is whether the definition of "available net income" includes provision for sinking fund and capital fund as deductions.

Accounting-wise, sinking and capital funds are dispositions of funds and not properly speaking income statement charges; and so in judging the higher grade income bonds for investment purposes, Graham and Dodd suggest not including such funds as part of fixed and contingent charges.  For lower grade income bonds, however, where probability of interest payment is the important factor, Graham and Dodd would include such funds as prior charges.  Consistency with regard to such funds as appropriations of surplus, rather than income account charges, and with regard to determination of grade, would seem to call for the same basis for analysis.  But note that probability of interest payment is the concern in the case of lower grade income bonds.

Income bonds issued under railroad reorganizations are callable, most of them at no premium.  By contrast, the Atchison Adjustment 4s, example of reorganization issue of an earlier day, are noncallable.  A number of the railroad income bonds are convertible, most of them into common but a few into preferred stock.

Some income bonds and adjustment bonds have split coupons, a portion fixed and a portion contingent.  In analysis, the entire interest (fixed and contingent) should be figured in applying the standards for income bonds generally, according to Graham and Dodd, as in their view the substantial margins of coverage required for investment grade would if met result in payment of both the fixed and contingent portions of interest.  It may be argued, however, that the step-up factor in figuring overall times fixed and contingent charges earned should apply only to the contingent interest portion of the coupon rates.

Under New York Stock Exchange's rules, fixed-interest bonds are traded "and interest," i.e., the seller receives accrued interest from last interest payment date on the bonds, in addition to the sale price.  Most income and adjustment bonds, however, have traded flat, without such accrued interest to the seller; although where such bonds have achieved a high quality rating, they may sell on an "and interest" basis, like fixed-interest bonds, as in the case of the Atchison, Topeka & Santa Fe Ry. Adjustment 4s.


GRAHAM, B., DODD, D. I., and COTTLE, S. Security Analysis, Principles and Technique, 4th ed., 1962.

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