Chapter 3 - The Selection Of Marketable Securities For Fixed Income Purposes

You will recall from chapter I that the reason so many people are now interested in marketable securities is because they have surplus funds. These funds they want to put to work (1) to expand their income, (2) to increase their capital, and (3) to assure financial serenity in later years. And, among most, there are high hopes that fortunate investments will make them rich.

This book has as its aim the development of your knowledge and skill in the successful handling of marketable securities. You have already learned of the early corporations and the marketable securities they created; then your attention was directed to the broad and varied markets where securities of every description are bought, sold, and quoted. So now, having a grasp of the wide selection of securities available and some understanding of the market structure, you are ready to consider the particular marketable securities you should buy with your own money. The selections you make depend importantly on two things: your own temperament and your financial objectives.

Are You the Conservative, Play-it-Safe Type?

Consider your temperament first. Are you a nervous, worrying type? If you lose money, are you inclined to brood over your loss? If you looked at an evening paper and saw that a stock you owned had dropped ten points that day, would it depress you? If the answer to these questions is "Yes," then let's face it: you're a conservative investor. Volatile, speculative securities will keep you in a constant state of jitters. Speculation is just not for you and, as you peer over the assortment of marketable securities available, the fixed income or steady dividend-paying stocks are the ones for you.

Let's cover the fixed income varieties first. These are bonds and preferred stocks. Actually, these are usually most attractive for purchase when the stock market is very high. At that time people in droves are so eager to own stocks that they will buy them at yields of 3% or less while fine bonds may go begging at yields of 5 to 5½%.

[Note: A yield is the percentage return an investment provides. It is found by dividing the indicated annual interest or dividend paid on a security by its market price. A $4 preferred stock selling at 80 thus yields 80/$4 or 5%. You figure it the same way with bonds. A $1,000, 4% bond selling at 80 (all bond prices are a percentage of par, usually $1,000) also yields 5% currently, namely, $800/$40. Actually, the yield to maturity is greater in the case of the bond selling at a discount since the bond will be ultimately paid off at $1,000, and the $200 discount ($1,000 ―$800=$200) will add to the yield by (roughly) an amount equal to $200 divided by the number of years to maturity. This may seem pretty technical stuff, but you ought to know about it because "yield" is one of the commonest words in the argot of Wall Street.]

Thus your consideration of fixed income securities depends somewhat on the attractiveness of the yield. If the yield on good bonds is only a little above prevailing savings bank interest rates, you'll probably prefer to keep your money in a non-fluctuating savings account rather than invest in bonds. Bonds are designed to preserve capital and deliver dependable income. Good bonds will fluctuate least of all marketable securities.

The Selection of Bonds

In making your own selections of bonds (if that's what you want to buy), you can get plenty of guidance. Life and fire insurance companies and savings banks are large holders of high-grade bonds. You can get a list of institutional holdings quite easily from annual reports or from a broker. The investment services, Standard and Poor's and Moody's, have a system of giving bonds a quality rating. If you confine your holdings to issues rated "A" or better by these services, you're bound to own a good list. The safest bonds are U. S. Government issues. Usually ranked next on a quality basis are prime municipals obligations of states and cities. Municipals are prized not only for their safety of principal and certainty of income but because the interest they pay is exempt from federal taxation; also from income taxes in the state of issuance. This provision can be of great value to wealthy individuals in the higher tax brackets. A 4% municipal can, if your income is high enough, be the equivalent of a 14% yield in taxable securities. (Wouldn't it be nice to be in that spot?)

In general, bonds of the highest quality have the lowest yield which is logical enough. Here's a random list of good bonds:

                                                     Interest          Kind
Issue                                              Rate(%)        of Bond         Maturity
Allied Chemical                              3½                Debenture     1978
American Tel. & Tel.                      3⅞                Debenture     1990
Columbia Gas & Electric                5                   Debenture     1982
General Motors Acceptance           4                   Debenture     1979
Northern Pacific                             4                   Prior Lien      1997
Pacific Gas & Electric                     5                   Debenture     1989
Socony                                           2½                Debenture     1976
Union Pacific                                  2½                Debenture     1991
U. S. Steel                                      4                   Debenture     1983

This list exudes quality. If you think you should get a higher yield than offered by these really "gilt-edged" bonds, then you can shop among the bonds of secondary railway lines and the smaller and less prestigious industrial companies. The highest bond yields are often found among railroad "income bonds." Returns on these may run from 5½% to 9%. A number of these issues sell "flat," that is, no accrued interest (from the last coupon date) is charged. Almost all other bonds sell with the interest added up to the day of delivery to the buyer.

Disadvantages of Bonds

Bonds are fine investment, wonderfully marketable, fine collateral, safe and steady income producers. But they have their defects. For many years in this century, particularly from the middle 1930's to 1952, bonds simply didn't yield enough to attract investors. Further, bonds are static investments. They offer no element of growth either in interest income or in principal value. Accordingly, they are not good investment vehicles for offsetting inflation and a shrinking dollar. The right bonds bought at the right time may deliver fine yields, and it is to bonds that shrewd investors turn for protection of their capital and salting away profits when stocks start to decline after a long rise.

Preferred Stocks

The second fixed income type security for conservative investors is the preferred stock. This must be selected much more carefully than a bond because, while bond interest must be paid, preferred dividend payments depend on earning power. In general, if a company earns bond interest three times over in a given year, the interest coverage is considered quite safe. A company should cover its preferred dividend, however, by a substantially higher multiple, preferably six times or more. The preferred stock you buy for sustained income should be issued by a strong and preferably large, well-established company. If it is callable, the call price should be high (115 or 120 for a $100 preferred) to compensate you for the redemption of your investment, especially if it has been paying a high dividend rate. Some companies specify that a certain percentage of net income be applied in a sinking fund to retire preferred shares. Your preferred stock should also be cumulative so that if it should pass its dividends in a year of poor earnings it may make up the payment to you later on. This cumulative feature, in a weak company, may not mean very much. There is the classic example of Rutland Railway 6% Preferred Stock which by 1951 had accumulated more than $300 a share in "back" dividends. (This was never paid off as the road went bankrupt and was reorganized.)

Representative preferred stocks would include those of American Can Co., Consolidated Edison, Bristol-Myers, Norfolk and Western, National Biscuit Co. (non-callable), Pacific Gas & Electric, Reynolds Tobacco, St. Regis Paper Co., and Tricontinental Corp.

Good preferreds will yield ½% to 1% more than bonds of comparable quality and will fluctuate more widely than bonds. The most popular preferred stocks among investors generally have been those of electric, gas and telephone utilities.

Sometimes preferred stocks have more than investment qualities to offer. Often they have voting privileges, and when a group is interested in gaining or retaining control of a corporation, this voting preferred may be bid up in the market because of its strategic value.

For those less daring by nature and motivated more by a desire to conserve than to expand capital, the fixed income marketable security bonds and preferreds which we've outlined in this chapter may prove useful. On the record, bonds are far more popular than preferred stock (which is regarded as a sort of hybrid between a bond and a common stock). Both securities are valued primarily for safety and stability. They won't make you rich but they can keep you from getting poor. They have some first cousins, however, the convertibles, which are far more flamboyant. They'll be discussed in chapter VII.

Resume

1. If you're ultra conservative and dislike wide fluctuation in securities buy bonds.

2. Bonds are the best buys when the stock market is very high.

3. Preferred stocks are attractive for yield but must be carefully selected.

4. Bonds and preferreds are limited in their return and are not (unless convertible) vehicles for important capital gain.

5. Fixed income securities are valued for the regularity of income they provide, but are not good defenses against inflation and the shrinking dollar.

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