The Grass Isn’t Always Greener.
As reported by FINRA.org.
Investors currently find themselves in a difficult investing environment. Yields on fixed-income investments are at historically low levels, and stock returns have been quite volatile. What’s an investor to do? Some investors are “chasing return,” meaning they are putting their assets into riskier and sometimes esoteric products that promise higher yields and returns than they can obtain in more traditional investments.
A number of investment products that may be appealing to investors interested in increasing their return have seen significant inflows as of late. For example, high-yield bond funds had $75 billion in new sales in 2010, and floating-rate loan funds grew from $15 billion in 2008 to $60 billion as of April 2011, a fourfold increase. Similarly, sales of structured retail products in 2010 rose by 38 percent over 2009, from roughly $33 to $54 billion1.
FINRA is issuing this alert because investors may not realize that they could be taking on more risk if they invest in products with higher returns. This alert discusses different ways investors are trying to increase their return—ranging from easily understood investments like high-yield bonds to complex vehicles like structured products and floating-rate loan funds. More importantly, this alert serves to remind investors that when they invest in products that promise higher returns they are nearly always taking on more risk.
A Challenging Environment
Investors face a challenging environment. Not only have monthly stock market returns been more volatile since the 2008 market drop than they were before, but investors have experienced two significant bear markets over the last decade. And yields on many fixed-income investments are at historically low levels. For example, the yield on a 10-year U.S. Treasury Bill is currently about 3 percent, a level last seen in the 1950s. Thirty years ago, yields on T-bills were nearly five times as high as they are currently.
This combination of low interest rates, stock price volatility and multiple bear markets has sent many investors looking for higher and more consistent returns. However, before moving your assets to another investment, there are several questions you should ask.
Questions to Ask Before Changing Investments
- Does the higher return from the investment come with increased risk? Invariably the answer is yes. The relationship between risk and return in the investment world is quite robust. The promise of higher return is almost always associated with greater risk and an increased possibility of investment losses.
- Do you understand how the investment operates? The quest for higher return could lead you to very complex investments, a sampling of which we describe below. If you do not fully understand how your investments function, you could find yourself surprised by outcomes you didn’t expect, such as illiquidity, exit fees, loss of principal or the return of your investment in a form other than cash.
- What are the costs and fees associated with the new investment? Not only is the promise of higher return associated with greater risk, but some of these investments have higher costs as well. For example, hedge funds and structured products can be very costly, and since some of the costs are built into their return, it can be difficult to know what you are truly paying.
- Is the product callable? Some investments are callable after a period of time, which means that the issuer can redeem the investment prior to the investment reaching maturity. For example, if interest rates fall, the issuer can save money by buying back an investment from you and issuing a new investment at a lower interest rate. If the issuer chooses to call the investment and you want to reinvest, you may find it difficult or impossible to find an equivalent investment paying rates as high as the original rate, a phenomenon known as reinvestment risk.
- Could the new investment be fraudulent? Legitimate investments that promise returns of 30, 50 or even 100 percent per year without any risk to your principal simply do not exist. Always independently verify who you are dealing with and whether the seller of the investment is licensed to do business with you. You can confirm the status of an individual broker or firm using FINRA’s BrokerCheck, and you can check on the status of an investment adviser or firm using the Investment Adviser Public Disclosure database.
Increasing Return—A Multitude of Choices
There are many ways investors could try to increase their return, and below we have listed and briefly described a number of these approaches. Some of these products are easily understood while others are quite complex, and not all are appropriate or relevant for every investor. What they do have in common is that they are all products that you might encounter if you are looking for higher returning investments.
A common method of chasing return is to move from investment grade bonds to high-yield bonds. However, when investors seek more robust returns in high-yield bonds, they are not escaping the fundamental tenet of investing we alluded to earlier—that is, higher returns are associated with higher risk.
High-yield bonds are bonds with lower credit ratings and a higher risk of default. As a result, the bond issuer has to pay a more attractive interest rate to compensate the investor for the additional risk. High-yield bonds can make sense in many portfolios, but remember that the higher yield may come with the increased possibility that you could lose money on your investment. For more information on high-yield bonds, see FINRA’s Smart Bond Investing.
Investor Tip—Individual Bonds vs. Bond Funds
If you are trying to increase your yield by investing in a bond mutual fund or Exchange Traded Fund (ETF) as opposed to individual bonds, remember that the value of your investment is not only affected by prevailing interest rates, but also by the willingness of investors to remain in the fund. For example, in a rising equity market, other investors might choose to leave the bond fund and seek higher returns by purchasing equities. As a result, the fund manager could be forced to liquidate bonds at a loss in order to pay out departing investors, which could drive down the value of the fund. So, even though you may have no intention of selling your bond shares, the decision of other investors to sell their positions could impact your overall yield.
For more important information about the differences between holding individual bonds and investing in one or more bond funds, see FINRA’s Smart Bond Investing.
Floating-Rate Loan Funds
Floating-rate loan funds have garnered a significant share of assets and attention during the past year. These funds invest in loans extended by financial institutions to entities of below investment-grade credit quality. They are sometimes called “leveraged” loans because companies that are extended these high interest loans usually have a significant level of debt relative to equity. Funds that invest in floating-rate loans may be appealing products to investors seeking greater returns because, in order to compensate lenders for taking on additional credit risk, the loans’ yields tend to be higher than investment grade bonds.
As their name implies, the interest rates on floating-rate loans adjust by a pre-determined spread over a reference rate, like the London Interbank Offered Rate (LIBOR). Funds that invest in floating-rate loans may be attractive in a low or rising interest rate environment because, in addition to having higher yields, the floating rate feature allows the fund’s interest rate to increase when rates rise. This is because the underlying interest rate on most floating-rate loans reset after a relatively short period of time, like 30, 60 or 90 days.
Unlike traditional fixed-income bonds, the market for floating-rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation and liquidity risk.
Structured Retail Products
Structured retail products are, generally speaking, unsecured debt with payoffs linked to a variety of underlying assets. These products can be attractive to investors because they can offer higher returns and might even feature a level of principal protection—meaning some or all of your initial investment may be guaranteed by the issuer if the investment is held to maturity or called, subject to the credit worthiness of the issuer. However, these products can have significant drawbacks such as credit risk, market risk, lack of liquidity and high hidden costs. In addition, they may be callable after a fairly shortperiod of time, like one year.
One example of a structured product is a “steepener,” which allows investors to bet on the shape of the yield curve. The return on this type of product is linked to the spread between longer- and shorter-term interest rates—that is, the so-called steepness of the curve. For example, the return on one widely available product increases when the yield curve steepens and decreases when the yield curve flattens. Steepeners can be appealing to investors chasing return because some of these products have initial fixed interest rates that are high, and these products are often principal protected, but they do have their drawbacks. The fixed rates often convert to floating rates that typically change in concert with the steepness of the yield curve, as described above, so your return can vary or fall over time. Moreover, they usually have longer maturities, the secondary market for these products may be illiquid and they are often callable.
Another example is a structured note with principal protection. These investments typically offer full or partial principal protection and reflect the combination of a zero-coupon bond with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. Structured notes with principal protection have the potential to outperform the total interest payment that would be paid on typical fixed interest rate bonds, so they may be attractive to investors seeking higher yielding investments. However, these notes also might underperform a typical fixed interest rate bond and could earn no return for the entire term of the note, even if you are holding the note to maturity. For more information on see FINRA’s Structured Notes with Principal Protection: Note the Terms of Your Investment.
Another category of investments some investors turn to when looking to boost returns is leveraged products. Whether the investment vehicle is an ETF or a mutual fund, the approach is the same. Leveraged products seek to deliver multiples of a specified benchmark by increasing exposure to the benchmark through the use of derivatives. “Inverse” leveraged products seek to deliver the opposite performance of the index or benchmark they track. For example, a leveraged ETF might seek to return two times the daily return of the S&P 500 while an Inverse ETF would seek to return minus two times the return of the index. So, if the S&P 500 returned 2 percent on a given day, the leveraged ETF would return 4 percent and the Inverse ETF would return -4 percent.
An important and sometimes misunderstood aspect of leveraged products is that they often “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time—over weeks or months or years—can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. That said, there are other versions of these products that have monthly resets or no resets, but they can also be difficult to understand. For more information on leveraged and inverse ETFs see FINRA’s Leveraged and Inversed ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.
There are many ways investors can chase return. The list of products described above is aimed at introducing you to a range of investments—from straight-forward to complex—that might be used for this purpose, but it is not an exhaustive list. For example, other investments that can be used to boost returns include preferred stock, private equity, funds of hedge funds and reverse exchangeable securities—and the list goes on. Regardless of what investments you are interested in, it is important that you take time to understand them and the risks involved.
Fraudulent High-Yield Investments
All of the categories of investments discussed to this point are legitimate investments that hold the possibility of higher return—and, as an investor, you need to weigh the possibility of earning a higher return against the higher risk and costs often associated with them. However, investors looking for higher returning investments may also come across fraudulent investments, including high-yield investment programs (HYIPs).
HYIPs are unregistered investments created and touted by unlicensed individuals, and they, typically, dangle the contradictory promises of safety coupled with very high, unsustainable rates of return. For more information about High-Yield Investment Programs and how to avoid falling prey to them, check out FINRA’s Investor Alert entitled HYIPs—High Yield Investment Programs Are Hazardous to Your Investment Portfolio.
If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at email@example.com