July 27, 2017

Terminology - "coupon bonds" versus "bearer bonds"

Are these terms equivalent? Well-l-l-l. Not really.

First off, I want to make it clear that I am talking about corporate railroad bonds. I am NOT talking about U.S. Treasury bonds and related securities.

Read practically any coupon bond and you will usually see that some company promised to pay a bank or individual OR BEARER a sum of money on a specific day. Why this phrasing?

Generally speaking, such a company would have given a mortgage on its assets to a wealthy individual or a large bank in return for money. Along with the "mortgage" or other contractual agreement would have been a large stack of bonds that formalized the repayment agreement in smaller denominations.

The bond at left is a $50,000,000 loan. Theoretically, the Cleveland Cincinnati Chicago & St Louis Railway Company would have given the Mercantile Trust Company a mortgage and $50,000,000 in bonds. In return the Trust Company would have given the company several million dollars right away, perhaps as much as $10 or $20 million. The Trust Company would then have marketed the CCC&StL bonds to its customers in return for cash and it would have subsequently lent the company more money over the ensuing months and years.

That does not mean all of the bonds were ever sold. That does not mean all, or even any, any of the bonds were sold for $1,000 each. Nor does it mean that the CCC&StL ever received the whole $50 million loan. After all, the Trust Company was taking quite a risk and wanted to be paid for that risk!

For ease of selling, this bond was issued to the "Mercantile Trust Company of New York, or bearer." Whoever bought any of the bonds from the Trust Company became owners the moment the bonds were handed over. No muss; no fuss.

Obviously, bearer bonds were wonderful assets when they needed to be sold quickly. Only buyers and seller were involved. And redeeming coupons was equally easy because they too were bearer instruments. Whoever turned coupons in for redemption were the ones who got paid.

However, bearer bonds and their attached coupons were terrible assets in the event of any kind of loss. Whether it was fire, flood, earthquake or theft, bearer bonds were rarely replaceable once lost.

The obvious solution was to register bonds with companies. Once a bond was registered, every sale needed to be recorded and that took time. But, at least the bond was safe.

The text of most bearer bonds allowed changing from bearer to registered status. For instance, the text of the CCC&StL bond clearly said, "or, if this bond be registered as hereinafter provided."

In the text that followed, the bond indicated that the bond, "may at any time and from time to time, be registered."

Huh? Does that mean what I think?

Yes, bearer bonds can be registered to a specific owner and then "registered" to a bearer and then registered to a new owner sometime later. Maybe even back and forth between registered and bearer status. Specifically, the text on this bond says, "until registration is made to bearer."

What happens to the coupons if a bond is registered?

Even though bearer bonds might be registered, the coupons can stay with the bond or they can be removed. Whatever the owner chooses. Specifically, "the owner of record may surrender all unpaid coupons hereof."

This particular bond was issued in May, 1893, shortly before the great Silver Crash. The registration panel on the back shows the bond remained as a bearer bond for 34 years before being registered by the New York Savings Bank in July, 1927. At that time, the Savings Bank decided to surrender the remaining 165 coupons in order to be paid directly by the company. The transfer agent made note of that fact by stamping the bond, "Coupons Detached."

The New York Savings Bank then held the bond through the Wall Street Crash of 1929 and the worst years of the Great Depression before ultimately selling it to Massachusetts Life Insurance Company in 1935. That company held the bond for the next 39 years before being transferred to the account of Bear, Stearns in 1974.

Three years later, the company was part of the large Penn Central bankruptcy and was being transferred to Conrail. At that time, the bond then went under the ownership of Warren Buffet who held it until it was permanently cancelled November 3, 1978. Buffet purchased the bond at a time when investors were arguing that railroad bonds such as this were either highly over-valued or high under-valued. I'd guess that Buffet paid no more than about $60 for this little investment. It was a time when interest rates were just starting to jump and when Conrail was negotiating how much to pay Penn Central bondholders. I do not know the outcome, but I seriously doubt Buffet lost any money.

What about an example of the opposite direction in registration?

I have only have one example and this is with a bond from the 999-year bond of the Elmira & Williamsport Rail Road Company issued during the Civil War. It originally had 100 coupons attached, but the bond was issued to Richard H. Downing, 'or assigns.'

A registered bond with coupons? Hmmm.

These bonds are entirely silent about the meaning of the word 'assigns.' There is a registration panel on the back which very similar to the CCC&StL bond. The E&W bond, however, shows absolutely no evidence of ownership for a century until it was transferred "to bearer" on Dec. 4, 1963.

Who had the bond during this period? Who cashed in all the coupons? All we can do is make some logical assumptions.

Those assumptions are that, 1) someone had possession of this bond for a century. 2) Someone, either Downing or his 'assigns,' collected about $5,000 worth of interest during that period. 3) For some reason, some legal owner expended the effort to convert the bond to bearer status in 1963. 4) There are absolutely no transfers recorded on the bond in the intervening period between 1863 and 1963. 5) It seems unlikely that someone presented proof of legal title every time they redeemed coupons.

Therefore, I assume that the word 'assigns' was interpreted as 'bearer' for the period between 1863 and 1963. For all intents and purposes, this coupon bond seems to have been a bearer bond for its entire lifespan. Or at least until September 3, 1982 when Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (aka TEFRA) that required that securities be registered in the name of the owner.

In conclusion, it appears that most coupon bonds have the ability to transform from bearer bonds to registered bonds and then back again. Secondarily, some old 'registered' bonds may not have been treated the same way as later registered bonds. Finally, the terms 'bearer' and 'registered' really involve the idea of protecting an investment from physical loss much more than the concern over how interest was going to be paid on that investment.

To which I say, it is no wonder beginners are sometimes stymied by bonds!