The income bond puzzle

The 1980's promise to be an exciting decade for American capital markets. Recent descriptions of our financial environment have featured such problems as capital shortages, inflation at unprecedented rates, and more than the usual amount of volatility and uncertainty in the credit markets. It is a time of financial innovation; deep discount bonds, GNMA pass-through securities, and financial futures and options are only a few of the new financing instruments that are now being developed and introduced at an unusually rapid pace. It is also a time of financial crisis, in which several very large publicly-held firms have failed or approached the brink of failure.

In such an environment, it is important for the practicing financial manager to be familiar with the full array of financial instruments at his disposal. Our intention in this article is to draw attention once again to a frequently advocated, but infrequently used class of corporate security: the income bond.

Before investigating this income bond “puzzle,” let's first review the features of the income bond.

Income bonds are hybrid instruments which combine the features of straight debt securities and preferred stock. Like straight debt, income bonds are a contractual obligation of the issuer; they give the holder a claim on the company's earnings that ranks ahead of all equities, preferred and common. At the same time, however, they represent a contingent claim: interest is payable only if earned. And, because the income bond is in fact a debt instrument, the interest payments are tax deductible to the corporate issuer.

That the payment of coupon interest depends on the level of the issuer's reported accounting earnings, is, of course, the most important characteristic distinguishing income bonds from other debt instruments. If sufficient accounting earnings are available after the deduction of operating expenses, allowable fixed asset depreciation, and interest payments with a prior claim on income, then the interest due on the income bonds must be paid. But if reported earnings (after deduction of the various allowed expenses) are not sufficient to cover contingent interest payments, the corporation may pass the payment with no change in the ownership structure of the company.

Thus, when a contingent interest payment is omitted, the bond technically is not in default, and bondholders obtain no additional control over the company (except for the possible future claim to accumulated interest). In contrast, when an interest payment is omitted on a fixed-interest bond, it is considered to be in default, and the bondholders may force the company into bankruptcy.

It is also worth noting, however, that income bonds can take on many of the characteristics of more conventional forms of debt. They may be callable, convertible into common stock, or subordinated to other classes of debt securities. They may contain sinking fund provisions. Also, and perhaps most important, the income bond, like preferred stock, may contain a provision for the accumulation of missed interest payments. As in the case of the dividend payments on both preferred and common stock, the interest payments associated with income bonds are “declared” by the board of directors. As a consequence, unlike other corporate bonds, income bonds trade “flat,” or without accrued interest.

Income bonds were first employed extensively in the railroad reorganizations that followed the panics of 1873, 1884, and 1893. After this period, income bonds were rarely used until the depression years of the 1930's. The Interstate Commerce Commission decreed that income bonds had no place in well-balanced capital structures and, in one extreme case, required the substitution of preferred stock for an income-bond issue.

During the 1930's companies with large funded debts and cyclical incomes found it necessary to reduce the fixed-income segment of their capital structures; income bonds were useful for this purpose, and were issued by both public utility and industrial firms. Around 1940, the ICC relaxed its position on income bonds, allowing for a marked increase in their use, mostly by railroads undergoing reorganization. And, in a dramatic departure from the prior decades, a number of solvent railroads issued income bonds in the early 1950's.

In a 1955 article published in the Harvard Business Review, Sidney Robbins surveyed the use of income bond financing by solvent corporations, and identified four or five industrial companies that had used them. Robbins noted that while income bonds afford virtually all the benefits of other debt instruments, they do not present the danger of “default risk” associated with conventional debt. That is, income bonds offer management greater flexibility when they need it most–when earnings are down. Other writers have also argued that income bonds offer all the advantages of preferred stock while providing the tax advantage of debt.

In the decade following Robbins' article, another handful of industrial companies floated small income bond issues. In fact, the president of Sheraton Corporation wrote a letter to the editor of the Harvard Business Review indicating that Sheraton had become interested in income bonds as a direct result of Robbins' article. (Sheraton ultimately sold $35 million of income bonds.)

In addition, several more railroads issued income bonds after publication of Robbins' article and, in 1961, Trans World Airlines completed an income bond financing. But, as characterized by Robbins, the use of income bonds remained “sparse and intermittent.”1

One notable exception to the general neglect of income bonds was the financing strategy of Gamble-Skogmo. In the mid-1960's, this large and prominent retail company built its financing program around the use of income bonds. The company first issued $15 million of income bonds in 1966, and thereafter entered the market every year through 1976. By 1976 Gamble-Skogmo had over $200 million of income bonds outstanding. Indeed, by 1974, the company had more income bondholders than common and preferred stockholders.

From the cases of Gamble-Skogmo, TWA, and the railroads, it is clear that income bonds have had a number of strong advocates among practitioners of corporate finance. Further, the writings of Robbins and other financial observers (see epigraph) are evidence of an income bond following among finance theorists.

Why, then, have income bonds not been used more frequently? There is a considerable amount of reluctance on the part of investment bankers, issuers, and investors that must be overcome before income bonds will be used extensively. Gamble-Skogmo, it should be noted, encountered such strong resistance from investment bankers that it had to form its own securities company to distribute its income bonds. But surely, in a competitive environment, if companies had been serious about pursuing income bond financing, they would have found investment bankers willing to accommodate them.

We now turn our attention to the fear that a change in the tax law will remove the tax deductibility of interest payments on income bonds.

First, it should be noted, companies that have issued income bonds have been able to deduct the interest payments for tax purposes. We confirmed this for each of the companies in our sample, either by conversations with the corporate treasurer or controller, or examination of corporate annual reports and published accounts of the bond issue.

Unfortunately, neither the US Congress nor the tax courts have defined precisely what features are necessary to establish that income bonds are indeed debt, and not a preferred stock equivalent. From tax court cases and IRS rulings, however, experts on the question have identified two important characteristics. First, the bonds must have a fixed maturity (This can, however, be fairly distant. An extreme case is the bond issued by Elmyra & Williamsport Railroad, with maturity set for the year 2862. A 30- to 50-year maturity is more typical). Second, contingent interest payments cannot be discretionary. This is generally interpreted to mean that interest payments must be paid if earned, and omitted payments must be cumulative and due, in any event, on the maturity date of the debt.

Conversations with the treasurers and tax attorneys of our sample of corporations issuing income bonds indicate that, in some instances, two other tests may be applied in lieu of the accumulation of omitted interest: income bondholders must rank equally with the corporation's other creditors in liquidation; and the bonds must have been issued in an “arms-length” transaction.

In short, provided income bonds retain the essential characteristics of valid debt obligations, interest deductions can be expected to continue to be allowed by the IRS. Concern about changes in the tax law should not deter companies from issuing income bonds.

We have seen that none of the reasons popularly offered for the scarcity of income bonds stands up to close scrutiny. We now switch our focus from the negative to the positive: is there empirical support for the alleged benefits of income bond financing? More precisely, is there any evidence that the market rewards companies for using income bonds?

In a recent paper, we attempted to test what happens to stock prices when companies issue income bonds to retire preferred stock.7 Briefly, our test involved a comparison of each company's common and preferred share price just before, and immediately after, the announcement of their intention to exchange income bonds for outstanding preferred stock.

If the market viewed the income bonds favorably, we should detect abnormally positive returns (arising from an increase in the stock price) at the time of announcement; negative stock returns would indicate an adverse reaction from the market. Similarly, returns that are “normal” for the systematic risk of the stocks would suggest neutrality, or indifference toward income bonds.

Our sample included 22 companies completing income bonds-for-preferred stock exchanges between 1954 and 1965. The value of the preferred stock involved in the average exchange, as a percent of the market value of the outstanding common stock, was 87.8 percent. The exchange offers thus represented, on average, a significant recapitalization of the sample companies.8

We analyzed both monthly and daily rates of return around the time of announcement.

The results of our monthly analysis indicated little impact on value. The common stocks of those companies exchanging income bonds for preferred stock had a positive, but small and not statistically significant, abnormal return. In the case of the preferred stocks the abnormal return was negative, but again small in absolute value and not significant statistically.

The results of our study of daily returns, however, were more telling. In measuring daily returns, we computed the average rates of return separately for the common and preferred stocks for the day of the exchange offer announcement, and for the five days preceding and following the announcement date. These results are presented in Table 3.

For the common stocks, we found an average abnormal return of 1.45 percent on the day of the first published announcement, and 0.73 percent on the announcement day plus one. While the announcement-day return is not extraordinarily large, it is, in statistical jargon, significantly different from zero. (The return on the day after announcement is not.) Thus, we can say, with great confidence, that this is not the result of random chance.

For the sample of preferred stocks we found an abnormal return of 1.01 percent on the announcement day and 1.47 percent on the day after. Neither of these can be attributed to random chance either.

There are two important points to note here. First, we again were not able to find any evidence consistent with the hypothesis that income bonds are somehow “tainted.” If this were true we would have found negative abnormal returns to shareholders around the announcement date. Second, and more important, we did find a clear, albeit small, market preference for income bonds. In sum, the theory and evidence, while contradicting the popular objections to income bond financing, provide fairly strong support for more extensive use of income bonds in corporate capital structures.

Thus, there appear to be no good reasons for the present neglect of income bonds. Given the instrument's unique characteristics, we think they can provide financial managers with increased flexibility in structuring their company's financing. Indeed, for those companies which view conventional debt financing as placing unacceptable constraints on their financing flexibility, income bonds may allow them to secure the tax advantage of debt without the attendant concern of meeting periodic interest payments, or facing the consequences of not doing so.

The failure of income bonds to gain acceptance thus remains a puzzle to us. But, in response to the same financial pressures that are giving rise to other financial innovations, the attention of investment bankers and their corporate clients will, of necessity, be directed once again to the largely unexploited benefits of income bond financing. A competitive market for financial advisors and financing instruments should ensure it.