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