Besides convertible bonds, there are other types of bonds which could be investment vehicles for substantial capital gains.

Some time ago there was a newspaper story of a bedridden Massachusetts farmer who swelled his initial $1,500 into millions by hunting out special situations. This farmer thought and read about the stock market every waking moment. He knew by heart the capitalization and earning power of almost every issue on the New York Stock Exchange.

His favorite purchases were preferred stocks with large accumulated dividends due and with their companies showing signs of strong earnings recovery. Bonds which were priced at big discounts from values of the properties behind them were also favored by him.

Preferred stocks with dividend arrears are generally highly speculative. The inability of companies to make full payments on their senior debts is strongly indicative of their marginal earning power or overcapitalization. In order to appraise the possibility of their earnings recovery, you would have to check earnings record, financial strength, management and many other things just as you would to invest in their common stocks.

In selecting preferreds, you should take a particularly hard look at a company's capital structure to see whether there is sufficient "equity cushion" behind them. Take Bethlehem Steel 7 per cent Cumulative Preferred as an illustration:

Capitalization (11-31-59)                                 ($ million)         Percent
Long-term debt                                                $   159,900      7%
Preferred stock (934,000 shs. @ $100)            93,400             4%
Common stock (45.4 million shs. @ 477/8—
closing price 1-20-60)                                      2,176,200        89%

TOTAL                                                            $2,429,500      100%

As you can readily see, the common stock at market value as of January 20, 1960, was about eight times the amount of debt and preferred stock. Such a preferred is said to be well "covered" or well "cushioned," which is usually entitled to a high market value (meaning lower yield). On the other hand, the market generally places a lower value (high yield) on a weakly "covered" preferred. So a combination of a high market equity with a high yield probably means a bargain, while a low yield with a low market equity most likely indicates an overpriced equity.

A high market equity is as important to a preferred as to a bond or convertible bond. The interest on the bond should be adequately (at least potentially) covered by a thick cushion of earning power at least in most years. Just as you shouldn't buy a preferred unless you like its common, so you must like the underlying common stock enough to fall in love with its bond or convertible. If you don't like the common stock in the first place, then it would make no sense to buy into its related bond or convertible bond carrying a privilege of conversion into something which is basically unattractive.

There are, of course, all types of discount bonds, including railroad bonds, municipal bonds which include both revenue bonds and general obligation municipal bonds and, as a matter of fact, any bonds selling at a considerable discount from their par or face value.
 
After sliding downhill for about a year and a half, bond prices in general touched bottom early in 1960 and have since then headed generally upward. The primary factor in their price recovery was a substantial slacking of economic growth in the 1960-61 period.

Despite this price recovery, many high-quality issues such as the ten "discount bonds" recommended by the October 5, 1960, edition of Financial World were found still selling at fairly wide discount from par. They were: Alabama Power 3½'s, 1972; American Tel. & Tel. 2¾'s, 1975; American Tobacco 3's, 1969; Cleveland Elec. Ilium. 3's, 1970; General Motors Acceptance 3's, 1969; Minneapolis-Honeywell 3.1's, 1972; Ohio Edison 3's, 1974; Pacific G.&E. 3's, 1971; Rochester G. & E. 34's, 1969; Standard Oil (N.J.) 2a's, 1971.

The chief reason they continually sell at wide discount from par is that they carry coupon rates which are still relatively low by today's standards. As a result, they should offer further capital appreciation possibilities. "Meanwhile," said Financial World, "the investor has a source of steady income; the rating of A or better accorded them by Standard `k Poor's indicates that both interest and principal are safe for all practical purposes. The chief risk in holding them is merely that associated with short-term fluctuations in the bond market—a risk that doesn't seem particularly large under present conditions.

Railroad bonds are another group of bonds mostly available at discount levels. In its January 11, 1961, issue, Financial World saw profit potential in ten medium-grade railroad bonds, six of which were involved in mergers. They were: Chicago, M.D., St. P. Sc Pac. 1st A 4's, 1994; Cleveland C.C. & St. L. Gen. A 4's, 1993; Great Northern Gen. N 38's, 1990; Illinois Central Con. A 3¼'s, 1979; Louisville & Nashville 1st Ref. G 2d's, 2003; Missouri Pacific 1st B 4¼'s, 1990; Northern Pacific Gen. 3's, 2047; Pennsylvania R.R. Gen. E 4¼'s, 1984; Southern Pacific 50-year 4½'s,  1981; and Wabash R.R. 1st B 3¼'s, 1971. During 1960, some of them sank to the lowest price levels since 1939, with most of them now still quoted at wide discounts from par.

In price behavior these medium-grade railroad bonds were seen by Financial World as having occupied a "midway position" between high-grade bonds at one end and the more speculative bonds and common stocks at the other. "On the one hand," said Financial World, "they are not so sensitive to shifts in interest rates as are top-grade senior equities. But neither do they respond so sharply to swings in the business cycles as do more speculative bonds and common stocks."

The possibilities for their eventual price comeback have been greatly enhanced by the far-reaching changes taking place in the nation's rail transportation system, chiefly in the form of major moves for greater operational economy and greater public efforts to help ease the carrier's plight through, among other things, possible elimination of competitive inequalities coming from public expenditures on waterways, highways and airways.

Municipal bonds are another broad group, many of which are attractively priced, with some of them at substantial discounts. Offered in a wide range of coupons and maturities, municipal bonds are issued to be outstanding for predetermined periods, which, in the words of Goodbody & Co., "gives diversification to the investor in that he can plan by a variety of means to put a small or large amount of money to work for a certain period of time, at a known return.

"For example, the purchase of a discount bond means the investment of an amount less than $1,000 or par, the realization over the life of the bond of full stated interest which is a percentage of $1,000, and the redemption at $1,000 of the bond at maturity. The actual yield takes into account the difference between what was paid and the matured price of $1,000, and the interest received over the period. Such bonds make good estate builders and are also used for such purposes as education and pension funds, when the larger amount of money is desired at some time in the future."

In September, 1960, Goodbody analysts singled out the New Housing Authority bonds as offering outstanding advantage for accumulating an. estate with a minimum outlay. New Housing Authority bonds are issued to construct housing developments for various cities and become, for all practical purposes, guaranteed by the federal government under the U.S. Housing Act of 1937, as amended, providing for a first pledge of annual contributions payable to the local housing authority in an amount which together with other funds of the local agency will be sufficient to pay the principal and the interest on the bonds when due.

Price differentials among localities' housing bonds come from the strong preference shown by many of the large institutional investors for the bonds of higher-rated cities, although the bonds of the most remote local housing authority have, in effect, the same security as the bonds of the top-rated city. Basically, it should always be advantageous to buy housing bonds of a low-rated city which are more likely to be priced at a discount.

When a discount bond reaches maturity or is sold, the investor naturally will have to pay a 25 per cent capital gains tax on the difference between the price at maturity or the sale price over the original price. Even with this capital gains tax, however, the discount housing bond was still found more profitable by Good-body analysts who gave the accompanying sample comparison of two bonds: (1) a current coupon housing bond; (2) a discount housing bond, both due in 1991.

                                                            3½% @ 100          2½% @ 3.5O
Original Cost                                        $1,000.00              $813.10
Interest Earned (for 31 years)                 1,085.00              775.00
Maturity Value                                        1,000.00              953.27*
Excess                                                    1,085.00              915.17

*This figure arrived at by taking 25% of the principal gain ($186.90) and subtracting it from $1,000 as the capital gains tax.

While the current coupon housing bond yields a profit of 108.5 per cent at the end of thirty-one years, the discount housing bond returns 112 per cent during the period.

Housing bonds are but one of the numerous revenue-type bonds which are municipal loans to obtain funds for a great variety of municipal services, including housing, redevelopment, toll facilities, electric, water and sewer systems. The so-called revenue bonds, payable from the revenues derived through operation of the facility the bonds were issued to construct, usually, though not necessarily, have more of an element of risk than general-obligation municipal bonds, payable from tax levies.

As in the case of other types of bonds, the degree of security in municipal bonds is directly proportional to its yield. The higher the yield, the greater the risk.

Whether revenue bonds or general-obligation bonds, they all enjoy the tax-exemption status of municipal bonds which result in a comparatively higher yield than nonmunicipals. Expert analysts offer a simple formula illustrating the difference in real income that an investor may obtain from tax-exempt bonds as opposed to what must be found in taxable securities to match the same real income.

Subtract your tax bracket from 100 and divide the tax-exempt yield by the result. The answer is the yield that must be found in a taxable security to match the "keeping dollars."

For example, suppose your tax bracket is 38 per cent.

100% — 38% = 62%
Assume a tax-exempt yield of 4.20%
4.20 ÷ 62 = 6.77%

A taxable security with a yield of 6.77 per cent must be found to equal the 4.20 per cent tax-free yield. This simple formula may be used on any bracket or yield.

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