Among Creditor Securities the best known and most popular are the debts of Governments, States and municipalities, the first named of which enjoy a prestige that has only been slightly dimmed by experience of the political risk attached to them, as proved by the war. In some countries, among which England stands pre-eminent, it may be doubted whether the prestige of Government stocks has been dimmed at all. The pre-war holder of Consols who has seen about 45 per cent. knocked off the capital value of his holding and the real value of his income divided by something like two, may still feel sore and surprised, but he is none the less convinced that he cannot be wrong if he buys British Government securities to-day, for safety of capital and certainty of income. The determined rapidity with which England teturned to the task of redeeming debt and meeting expenditure out of revenue, at a time when all kinds of specious arguments could be and were put forward for a policy more comfortable to the tax-payer, has raised her financial reputation higher than it ever was before; and it is interesting to note that when a Labour Government was in office, its Chancellor of the Exchequer, Mr. Philip Snowden, talked with all the earnestness of a bank chairman about the importance of maintaining British credit, and brought in a sound Whig Budget which might have been opened by Mr. Gladstone. It is, however, also important to remember that the Labour Government was in office but not in power, since it had not a majority of the House of Commons behind it.
When we come to look at British or any other Government debt or any other security, with that coldly sceptical eye that should be turned upon it by the investor, the real question that we have to ask about it is what is the income behind it, out of which we can rely on the debtor's being able to meet the interest and pay the debt when and if due for redemption. And it is rather disconcerting to find how much uncertainty there always is, though the degree of uncertainty varies, in answering this question.
Concerning the British Government, for example, we know that during the last completed financial year it collected a revenue of £799½ millions, and paid in expenditure £795¾ millions, of which £312 millions went in interest on debt and £45 millions in debt redemption. But if we want to know what is the real margin of security—how many times over our interest is covered, as an industrial prospectus would put it—we very soon find ourselves in the region of guess-work.
Statisticians are most ready to oblige with estimates of the aggregate income of the citizens of the country, the whole of which, according to the principle of jurisprudence laid down by Austin, the Government has the right to appropriate for the public purse. But we know very well that there are limits beyond which no Government can go in taxation, and we also know that nobody can say with any approach to exactitude what those limits really are, because they vary according to the mood of the tax-payer and his willingness to part with his income to meet a national emergency.
All that we know or think that we know on this point about England is that:—
1. Owing to a certain blind commonsense which is the priceless asset of her public finance, there never, unless the whole character of the nation changes, will come a time when her statesmen will lay on her back a debt that she cannot face, or when they, or the public opinion of the nation, would begin to think about considering the question of doing anything else but meeting the interest punctually and in full.
2. If the proposal for a levy on capital should ever be revived, we may be sure that the Government, in order to maintain its own credit and borrowing power, will see that holders of Government debt will not be worse, but if anything better, treated than owners of any other kind of property.
3. England has shown and still shows that she possesses stores of economic strength that escape calculation and only appear when an emergency arises.
4. In the summer of 1925, when our trade had been suffering from severe depression and we were supporting over a million and a quarter of unemployed and their families, and when we were repeatedly told that the country was groaning under the weight of taxation, the spending power of all classes of the community appeared to be quite unaffected; sleeping-cars to Scotland for the opening of the grouse season were booked in advance by the railways to an unprecedented extent; and Lancashire operatives, after years of depression and short time in the cotton trade, spent more than twice as much (though in depreciated currency) as in 1913 on the August "wakes," or holidays, for which they save all through the year.
5. The present industrial difficulties, of which the state of the coal trade is the extreme example, will be settled, whether amicably or after deplorable conflict, by a recognition of the fact that British trade can only live if it can compete abroad, and that all concerned in it have to work together to that end.
And on these facts and beliefs we think that British Government security is just as good as it can be. But we have to admit that the data on which we base this sentiment are far from being capable of exact calculation, and that the sentiment may be coloured by the popular prejudice known as patriotism.
Having arrived at this conclusion concerning the solvency of the debtor we go on to decide what sort of a contract we are prepared to conclude with him, that is, which of the varieties of the British Government stocks now in the market, or on continuous offer, we think most suitable to the ordinary investor.
There is one rather serious objection to them all, which is that they are a "fancy article "with a special demand for them, because to many important financial institutions they are as necessary as office furniture, since custom and the exigencies of financial respectability make a holding of them essential; and when a security or any other article is one that has to be bought by a certain number of people, the consequence is that the price is to a certain extent artificial, and that it should, as a general rule, be avoided for that reason by those who are not obliged to have it. This principle also applies to all the other stocks that are known as "trustee securities," as to which more will have to be said later.
Nevertheless, there are certain British Government securities with special privileges attached to them, which outweigh the objection above noted. Apart from safety of income, the pleasantest feature about a security is the power of its holder to demand his money back in full and at once, and the National Savings Certificates that are on continuous sale at our banks and post offices confer this privilege on the holder, and the still more important one—to those whose incomes are large enough to be taxed and supertaxed—that the interest from them, which is not paid but accumulates to the holder's credit, need not be included in any statement of income made for purposes of taxation. The interest on these certificates has been drastically reduced, and to those who buy the Third Series and hold them for ten years, the yield works out at about 4⅛ per cent; but their freedom from income tax makes them, to those liable to it, the highest yielding Government security, and a very solid foundation for every investor's collection. The fact that they yield no present income but accumulate at compound interest is not altogether a disadvantage since it means that they are not only an investment but a form of continual saving. The drawback to them is that no one can hold more than five hundred one pound certificates, now to be bought at sixteen shillings, and growing to their face value in five years' time. They are an ideal form of saving, in safety, rate of interest, freedom from taxation and prompt convertibility into cash with accrued interest, if need for cash should arise.
Another British Government security with a special privilege attached is Victory Bonds, which are accepted at their face value in payment of Estate Duties. As long as they can be bought at a considerable discount they thus make death a profitable transaction to the holder to the extent of his liability for Estate Duties, which are the toll that the State takes of his possessions on their transfer to his heirs. Moreover, bonds that are handed to the State in payment of Estate Duties are held by the National Debt Commissioners, so that what may be described as a special Sinking Fund is continually in operation to reduce the amount, and raise the price of those that are left in the market. These advantages, however, that are attached to Victory Bonds are, to a certain extent, "in the price." At the present moment the yield from them is less than that to be got from the 3½ per cent. Conversion Loan, now the most popular of British Government Securities, and perhaps the most suitable, after Savings Certificates, for the investor who wants one with no probability of early redemption.
Consideration of the beauties of these securities has revealed to us the qualities that we need in a desirable investment of the creditor class. By far the most important point is certainty of income out of which interest can be paid, and certainty of getting back our money if we want it is a pleasant and convenient addition. In the case of Savings Certificates, return of our money on demand with interest accrued is part of the contract with the debtor, and is an almost unique feature shared only by Savings Bank deposits which carry a much lower rate of interest. In that of Victory Bonds we get our money back plus a considerable premium, as long as they have been bought below par, when our executors pay Estate Duty, and they thus only carry this special advantage when held by investors whose estate is large enough to be taxed. In the case of all other securities dealt in in the stock markets, the investor can only get his money back by waiting for the date of redemption, if any, or for the chance of having his bond drawn for repayment, if the security is redeemed by a sinking fund operating in this manner, or by selling in the market at the current price.
And so we arrive at the terms of debt redemption, which are the next question to be considered, after the certainty of the interest payment. Those investors whose circumstances are such that a need to turn their holdings into cash is a highly improbable contingency and only want a collection of stocks that they can sleep on soundly, can take securities with a very remote date of redemption or perpetual securities which are definitely labelled as irredeemable. To such an investor, however, it is very important to be sure that the debtor has not got an option of redeeming if it suits him to do so. For example, the 5 per cent. War Loan can be paid off at par at any time after 1929, so that after that date its holders will be in danger of having their money, or the face value of their stock, returned to them if the Government is at any time able to borrow at a rate of interest lower than the one which it is paying on the stock. The fact that it is able so to borrow necessarily means that stock prices are relatively high and the yield to the buyer is consequently low, so that the investor will have his money thrown back at him at a time when it is difficult for him to reinvest to his own satisfaction.
A large number of creditor securities has lately been issued with this option in favour of the borrower—stocks with a life of thirty years or so with an option to the debtor to redeem at any time aften ten years from the date of issue. Obviously such stocks are not so pleasant to hold as those which are definitely redeemable either at the end of thirty years or at the end of ten years. In the first case the investor has the certainty of a comfortable rate of interest for a long time; in the second the short life of the security helps to keep its price steady. With a ten-thirty year stock the borrower is made comfortable at the expense of the investor, who stands to lose whether the ruling rate of interest rises or falls.
With regard to all creditor securities that are redeemable at a date it is important that the debtor should not only engage to repay but to make annual provision during the life of the loan for its extinction on or by that date. Debtors with very high credit have been able in times past to dispense with this obligation, but the financial exigencies of the war and after-war period have obliged the Governments of the highest standing to spread the jam thick on securities that they offer to the public, and the British 5 per cent. War Loan carries with it an obligation on the part of the Government, wheneven the market price of the stock is below 95 to set aside one-eighth per cent. of the outstanding amount of the loan each month to be used in the purchase of stock in the market; with the result that if the stock stood below 95 for a year there would be in effect a 1½ per cent. Sinking Fund, operating by purchase in the market. It is now some time since this provision has been effective, but it was at one time a valuable prop to the price of the stock. The 3½ per cent. Conversion Loan has a still more effective Sinking Fund clause in its contract which obliges the Government whenever the stock is below 90 to redeem each year 2 per cent. of its outstanding amount. Owing to the low rate of interest and consequent low price of the stock in the market, the effectiveness of this Sinking Fund, which is calculated, of course, on the face value of the stock, is all the greater. When the stock can be bought at 75 a nominally 2 per cent. Sinking Fund actually buys 2⅔ per cent. of the outstanding issue.
For investment in Home Public Debts the buyer's range is practically confined to the obligations of the British Government and those of the municipalities and counties. We saw, when we considered our reasons for the belief that our Government securities are as safe and sound as any securities can be, that these reasons are to a great extent based on considerations which are not capable of exact calculation, that there is a good deal of sentiment behind them, and that this sentiment may be prejudiced by patriotism. When we come to investigate the security behind municipal and county debts, we find the same thing only rather more so, with, however, one advantage in their favour, that they are not debts that have been raised purely for the purpose of waging war.
With them, as with all securities, the most important consideration for the buyer is the income out of which the debtor can meet interest and provide for repayment. This income is derived from the power of the municipal and county authorities to levy and collect the local taxes known as rates from the inhabitants of the area; and any attempt to arrive at an exact estimate of the extent of this power is at least as difficult, if not more so, in the case of a local body than in that of the Government.
It is unthinkable, in the belief of most of us, that the British Government would ever incur debts that the nation could not meet; but one does not feel quite so certain about the local authorities, especially as the basis on which they assess their sheep for the shearing process is not nearly so sound. The Government, as we all know, taxes us on our incomes, on our purchases of certain goods, such as drink, tobacco and tea, and on the value of our estates when we die. The local authorities tax us according to the alleged value of the houses that we inhabit or the premises that we occupy for business purposes.
The difference between the two systems of assessment, and the advantage in favour of that which is employed by the Government is at once evident. Anyone who is receiving an income, spending money on articles which are not—though we may have come to regard them as such—necessaries of life, or leaving an estate, evidently has money out of which he can pay taxes. But the mere fact of living in a house or occupying premises for business by no means necessarily implies capacity to pay rates; on the contrary, if misfortune falls on the rate-payer his house or factory is a source of expense. A man whose income is a minus quantity and lives in a house on which he pays a rent of £100 a year is not a satisfactory subject of taxation.
You may say that he ought not to be living in such a house, and he will quite agree, but will point out that when he signed a contract by which he became its tenant for seven years he was making a good income which he did not expect to disappear; that he would be delighted to sub-let if he could find someone who would take the house, but that owing to bad times and the fact of the high rates charged by the municipality it is impossible for him to do so. A big shop or a great factory employing large numbers of workers and having to pay rates based on the value of the premises, whether it is earning nothing, little or a fortune in the way of net profit, is also evidently being taxed on a wholly unscientific basis, which lays a devastating burden, in bad times, on production and commerce.
It may be said, as a rough generalization not to be examined too critically, that the Government taxes us according to our assets, and the local authorities according to our liabilities. From such a system there is danger of evil consequences for the rate-payer and for the municipality and so ultimately for the investor who buys the municipality's debts. If rates rise too high—and every rate-payer is inclined to regard his rates as too high—they tend to cause a lowering of rents and consequently of valuations for rates, and so the municipality has to impose a still higher rate on a lower valuation, and so increase the evil, or else reduce its expenditure which, like most public bodies that spend other people's money, it finds a very difficult task and highly unpopular with those on whom the expenditure is spent. If the evil becomes too acute, it may drive the inhabitants, residential, commercial and industrial, out of the area. Short of that it stops growth and makes anyone, who can do so, live or work anywhere else. Witness the tendency, already evident, of factories to be built outside urban areas in England; a tendency that may be a good deal quickened if and when any practical result comes from the schemes of electrical power distribution, about which much has lately been said.
Nevertheless, most of us believe that there never can be a question of the solvency of any of the great English towns, and have no hesitation in regarding their debts as almost as gilt-edged as those of the British Government. The fact remains, however, that the much narrower area of taxable capacity that they cover, the power of that taxable capacity to shift from one centre to another owing to changes of trade conditions, and the unsound basis on which local rates are collected are disadvantages that cannot be altogether forgotten by the prudent investor.
On the other hand, there is this to be said of municipal debts, that they usually represent something more solid than the long series of wars more or less successfully waged, which are by far the largest asset that we can find to put into the balance-sheet against the seven thousand millions of British debt. But assets are of little advantage to the creditor if from their nature they are unsaleable and if they are not producers of net revenue. And the kind of assets that municipalities own—public parks, tramway systems, sewers, water supply and so forth—are not the sort of article that can be put up to auction and sold if the municipal area has fallen on such evil days that the municipality's power to meet its debt charges is doubtful. They are revenue producing, if at all, only as part of a going concern, and their "old iron" value is practically nil, if extravagance and bad finance on the part of the local authority should result in a level of local rates, high enough to check and reverse the progress of the area covered. We come back to revenue, as we always shall in looking at all kinds of securities, as the real test on which the desirability of municipal debts is based, and though comparisons may be made of the rates in the pound charged by the different municipalities, they have little meaning unless the investor who studies them is fully informed concerning local conditions and the prosperity and prospects of the industries and trades of the place.
In considering individual securities offered by the local authorities, we have to make sure of the same points that were indicated as essential with regard to Home Government stocks. That is, we want to be sure that the stock is either definitely redeemable at a date or definitely irredeemable, and that redeemable means that it must be paid off, and not that the debtor has the right to redeem if it suits him. Also that there is no option in his favour of redemption if it suits him, at any time after such and such a date. And that the debtor is bound under the terms of the issue to set aside each year a sum that will suffice to provide for redemption of the debt on maturity. Rateable value has been shown to be a not wholly impregnable foundation on which to raise a skyscraping erection of debt; and there is all the more reason for preferring the debts of a municipality whose total debt is small as compared with the estimated rateable value of its area. But most investors are content with the fact that the debts of municipalities with a certain population are "trustee securities" and may, therefore, be assumed to be immaculate. It is high time to deal with this assumption.