By Montgomery G. Griffin and Theodore S. Avery
Elderly investors seeking income and relative stability of their principal are often encouraged by their broker or financial advisor to buy bonds (or bond funds). Often, high-yield bonds, and their high risks, are not suitable investments for elderly and retired investors due to the higher probability (vis-à-vis high quality, investment grade bonds) that a loss of principal could occur. However, most investors do not understand the high risks inherent in owning certain types of bonds generally known as “high yield bonds,” “high yield securities,” or in their purest form: “junk bonds.” And, the amount of bonds underwritten (and, thus, sold to investors) by Wall Street firms has increased significantly in recent years. Indeed, on August 18, 2019, the Wall Street Journal reported that over the past decade the low interest rate environment has caused corporations to “bulk up” on the issuance of debt and, more specifically, that “about half” of all investment-grade debt is now rated BBB, the lowest rating in the investment-grade category.
Many investors simply do not appreciate the risks inherent in their fixed-income portfolios. While bonds are often suitable for investors seeking steady income from their investments, it is critical to understand that not all bonds and bond funds are created equal. Bonds and bond funds with higher relative yields pay more for good reason: they carry substantially more risk than other, lower-yielding bonds and bond funds. It is incumbent upon brokers and financial advisors to ensure that clients understand the risks associated with any and all recommended investments. Indeed, the duty to fully disclose all material risks by financial advisors—particularly with regard to higher risk investments—is an age-old requirement in the securities industry. Moreover, FINRA rules require a financial advisor to make a “balanced sales presentation” whenever recommending an investment—which, of course, means that the risks and costs should be fully and fairly explained to the investor.
Additionally, regardless of risk disclosures, FINRA Rule 2111 provides that brokers and financial advisors may only recommend investments that are suitable for the client, taking into consideration factors that include the client’s investment objectives, age, financial circumstances, and risk tolerance.
Unfortunately, brokers and advisors sometimes fail to comply with these standards. To make matters worse, their failure is not always merely reckless: brokers and financial advisors may obtain higher commissions or fees by having their clients invest in high-yield bonds or bond funds versus the commissions often available to financial advisors for short-term, high-quality bond investments.
Securities industry regulators have long focused on the risks involved with owning high-yield, or junk, bonds. For example, the Financial Industry Regulatory Authority (“FINRA”) has warned that you should “slow down when you see ‘high yield.’” One reason an investor should “slow down” is that high-yield bonds typically have low credit ratings, meaning that there is a heightened risk that the issuers will default and stop paying interest on the bonds and/or be unable to return an investor his or her principal upon the bond’s maturity date. Credit rating agencies (such as Moody’s or Standard and Poor’s) evaluate bonds and assign them letter-grade ratings based on the agency’s assessment of the bond’s credit quality. (Specific bonds’ credit ratings are sometimes listed next to the bonds on monthly account statements.) These ratings range from “AAA” (for Standard and Poor’s) and “Aaa” (for Moody’s), indicating that the bond issuer’s capacity to meet its financial commitments on the bonds is extremely strong, down to “D” (Standard and Poor’s) or “C” (Moody’s), indicating that the bonds are in default. Bonds rated BBB (Standard and Poor’s), Baa (Moody’s), or higher generally have low-to-medium credit risk and are referred to as “investment grade” bonds. Conversely, bonds rated BB (Standard & Poor’s), Ba (Moody’s), or lower generally have high credit risk and are aptly referred to as “junk” bonds. Bonds with lower credit ratings tend to offer higher yields to entice investors to purchase the bonds despite their weaker credit worthiness. Indeed, this relationship between yield and credit rating is so strong that “high yield bonds” and “junk bonds” are considered synonyms in the industry.
The credit risk that accompanies most high yield bonds also makes them exceptionally sensitive to changes in industry or economic conditions. Issuers of junk bonds are likely to struggle against industry or economic headwinds, exacerbating their risk of default. Additionally, during times of economic uncertainty, investors tend to sell riskier assets (such as junk bonds) and purchase lower risk assets (such as investment grade bonds or treasuries), which drives junk bond prices lower and further punishes investors who own junk bonds in their portfolios.
While credit risk is the most common reason a bond offers a high yield, it is not the only reason. For instance, a bond from a foreign issuer may offer a higher yield due to liquidity or currency risks. But regardless of what risks are driving the yield, “high yield” reliably signals high risk. Many investors may not be aware of the relationship between high yields and risk, and others may not know enough about the complexities of the marketplace to even understand what would constitute a high yield—thus making it imperative for financial advisors to explain such risks in easy-to-understand terms.
Instead of purchasing individual bonds, investors also sometimes purchase (and brokers and advisors recommend) bond funds. Bond funds are funds that hold a portfolio of bonds. Bond funds can have advantages over individual bonds, such as by offering monthly (rather than semi-annual) payouts or easy diversification (by holding a large array of bonds). But, bond funds are not necessarily sound or suitable investments. The holdings of a given bond fund may be skewed toward bonds with lower credit ratings, such as junk bonds, meaning that the bond fund still faces exceptional credit risks. It may also be more difficult for investors to recognize the credit risk of bond funds’ holdings because bond funds themselves do not have a straight-forward credit rating like individual bonds. Further confounding the matter, it is not uncommon for bond funds to take on names like “Opportunity & Income,” “Enhanced Yield,” or “Income Advantage” that obscure the poor credit ratings of their holdings.
Bond funds also can also have drawbacks and special risks beyond those of the bonds they hold. For instance, bond funds have management fees called “expense ratios” that can be substantial and can eat into profits or add to losses. In addition, bond funds may employ leverage, which can dramatically ramp up the risk of loss of the fund regardless of the quality of bonds they invest in. Some bond funds have substantial sales loads, which are nothing more than commissions paid to the institution that sold you the investment (such as your brokerage firm). (Indeed, these sales loads can be the primary motivation behind an unscrupulous broker’s recommendation of a particular bond fund.)
When it comes to bonds and bond funds, high yields can lead to big problems in a portfolio. If you have securities accounts under the guidance of a broker or financial advisor that you worry might have underperformed due to high-yield bond investments in your accounts, consider contacting an attorney who specializes in having investment performance analyzed and seeking recovery of investors’ investment losses. To contact the Law Offices of Montgomery G. Griffin, click on the contact link below.