Default Risk 177Santa Fe Bonds Finally Mature after 114 Years
In 1995, Santa Fe Pacific Company made the final payment
on some outstanding bonds that were originally issued in
1881! While the bonds were paid off in full, their history has
been anything but routine.
Since the bonds were issued in 1881, investors have seen
Santa Fe go through two bankruptcy reorganizations, two
depressions, several recessions, two world wars, and the col-
lapse of the gold standard. Through it all, the company re-
mained intact, although ironically it did agree to be acquired
by Burlington Northern just prior to the bonds’ maturity.
When the bonds were issued in 1881, they had a 6 per-
cent coupon. After a promising start, competition in the rail-
road business, along with the Depression of 1893, dealt a
crippling one-two punch to the company’s fortunes. After
two bankruptcy reorganizations—and two new management
teams—the company got back on its feet, and in 1895 it re-
placed the original bonds with new 100-year bonds. The
new bonds, sanctioned by the Bankruptcy Court, matured in
1995 and carried a 4 percent coupon. However, they also
had a wrinkle that was in effect until 1900—the company
could skip the coupon payment if, in management’s opinion,
earnings were not sufficiently high to service the debt. After
1900, the company could no longer just ignore the coupon,
but it did have the option of deferring the payments if man-
agement deemed deferral necessary. In the late 1890s, Santa
Fe did skip the interest, and the bonds sold at an all-time low
of $285 (28.5% of par) in 1896. The bonds reached a peak in
1946, when they sold for $1,312.50 in the strong, low inter-
est rate economy after World War II.
Interestingly, the bonds’ principal payment was originally
pegged to the price of gold, meaning that the principal re-
ceived at maturity would increase if the price of gold in-
creased. This type of contract was declared invalid in 1933
by President Roosevelt and Congress, and the decision was
upheld by the Supreme Court in a 5–4 vote. If just one
Supreme Court justice had gone the other way, then, due to
an increase in the price of gold, the bonds would have been
worth $18,626 rather than $1,000 when they matured in
1995!
In many ways, the saga of the Santa Fe bonds is a testa-
ment to the stability of the U.S. financial system. On the
other hand, it illustrates the many types of risks that in-
vestors face when they purchase long-term bonds. Investors
in the 100-year bonds issued by Disney and Coca-Cola,
among others, should perhaps take note.Service of New Hampshire financed construction of its troubled Seabrook nuclear
plant with junk bonds, and junk bonds were used by Ted Turner to finance the devel-
opment of CNN and Turner Broadcasting. In junk bond deals, the debt ratio is gen-
erally extremely high, so the bondholders must bear as much risk as stockholders nor-
mally would. The bonds’ yields reflect this fact—a promised return of 25 percent per
annum was required to sell some Public Service of New Hampshire bonds.
The emergence of junk bonds as an important type of debt is another example of
how the investment banking industry adjusts to and facilitates new developments in
capital markets. In the 1980s, mergers and takeovers increased dramatically. People
like T. Boone Pickens and Henry Kravis thought that certain old-line, established
companies were run inefficiently and were financed too conservatively, and they
wanted to take these companies over and restructure them. Michael Milken and his
staff at Drexel Burnham Lambert began an active campaign to persuade certain insti-
tutions (often S&Ls) to purchase high-yield bonds. Milken developed expertise in
putting together deals that were attractive to the institutions yet feasible in the sense
that projected cash flows were sufficient to meet the required interest payments. The
fact that interest on the bonds was tax deductible, combined with the much higher
debt ratios of the restructured firms, also increased after-tax cash flows and helped
make the deals feasible.
The development of junk bond financing has done much to reshape the U.S. fi-
nancial scene. The existence of these securities contributed to the loss of indepen-
dence of Gulf Oil and hundreds of other companies, and it led to major shake-ups in
such companies as CBS, Union Carbide, and USX (formerly U.S. Steel). It also caused