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Chapter 22: Privileged Issues

In addition to enjoying a prior claim for fixed amount of principal and income, a bond or preferred stock may also be given the right to share in benefits accruing to the common stock. These privileges are of three kinds:

a)    Convertible – conferring the right to exchange the senior issue for common stock.

b)    Participating – additional income may be paid to senior security holder, usually based upon the amount of common dividends declared.

c)    Subscription – holders of bond or preferred stock may purchase common shares, at prices, amounts and during periods stipulated.

These issues must be considered very attractive in form, since they permit the combination of maximum safety with the chance of unlimited appreciation in value. Despite this impressive argument in favor of privileged senior issues as a form of investment, actual experience with this class has not been generally satisfactory. This discrepancy between promise and performance is due to two reasons. The first reason is that only a small fraction of the privileged issues have actually met the rigorous requirements of a sound investment.

The second reason is related to the conditions under which profit may accrue from the conversion privilege. After a privileged issue has advanced with common stock, its price soon becomes dependent in both directions upon changes in the stock quotation, and to that extent the continued holding of the senior issue becomes a speculative operation.

Example: A high grade 3.5% bond trading at par, convertible into two shares of common for each $100 bond (convertible into common at 50). Common is selling at 45 when the bond is bought at par.

The unlimited profit possibilities of a privileged issue are thus in an important sense illusory. They must be identified not with the ownership of a bond or preferred stock but with the assumption of a common stock holder’s position – which any holder of a non-convertible may effect by exchanging his bond for a stock. Practically, the range of profit possibilities for a convertible issue, while still maintaining the advantage of an investment holding, must usually be limited to somewhere between 25 and 35% of its face value. For this reason original purchasers of privileged issues do not ordinarily hold them for more than a small fraction of the maximum market gains possible and consequently do not realize these very large profits. Thus profits taken may not offset the losses occasioned by unsound commitments in this field.

These objections must considerably temper any enthusiasm for privileged senior issues as a class, but they by no means destroy their inherent advantages not the possibilities of exploiting them with reasonable success.

Principle for Investing in Convertible Security: A privileged senior issue, selling close to or above face value, must meet the requirements either of a straight fixed value investment or a straight common stock speculation, and it must be bought with one or the other qualification clearly in view.

Rules for Sale or Retention after a Convertible Security is Bought: Convertibles bought primarily as a form of commitment in the common stock may be held for a larger profit than those acquired from the investment standpoint. If a bond of the former class advances from 100 to 150, the large premium need not in itself be a controlling reason for selling out; the owner must be guided rather by his views as to whether or not the common has advanced enough to justify taking his profits. But when the purchase is made primarily as a safe bond investment, then the limitation on the amount of profit that can conservatively be waited for comes directly into play. The conservative buyer of convertibles will not ordinarily hold them for more than 25 to 35% advance. This means the really successful investment operation in the convertible field does not cover a long period of time. Hence such issues should be bought with the possibility of long term holding in mind but with the hope that the potential profit will be realized fairly soon.

A continued policy of investment in privileged issues would, under favorable conditions, require rather frequent taking of profits and replacement by new securities not selling at an excessive premium. It is not likely that satisfactory opportunities of this kind will be continuously available or that the investor would have the means of locating all those that are at hand.

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