The paltry returns from many traditional income investments like government bonds and CDs and the volatility of stocks have inspired brokers to push investments that promise high yields, but often carry hidden dangers. According to a recent release from the Financial Industry Regulatory Authority (FINRA), these kind of investments include high-yield bonds, floating-rate loan funds and a variety of other options. FINRA points out that hundreds of billions of dollars of these products have been sold to investors since the 2008 market downturn.
Investors should never make a decision just by looking at an investments return but should also make sure they understand what fees are involved and how the investment works, said Gerri Walsh, FINRA’s vice president for investor education.
For instance, investors in structured retail products could end up with securities plagued by hidden costs, lack of liquidity and credit risk, according to FINRA. These products are most often unsecured debts whose payoffs are linked to a variety of underlying assets. For a more detailed description of several types of structured products on the market, look at the Investment Products section of our website.
FINRA identified several types of products that are cause for concern:
High-Yield Bonds: Allocating a small portion of one’s fixed income holdings to higher yield bonds could make sense in some portfolios. But clients don’t always understand that the higher interest rate comes hand in hand with greater risk in the form of lower credit ratings and a bigger chance of default.
Floating-Rate Loan Funds: These are investments in loans made to institutions with below-investment-grade credit. These funds may be marketed as being less vulnerable to fluctuations in interest rates and safer from inflation, says FINRA, but in fact the underlying loans have significant risks that affect liquidity, value and credit.
Structured Retail Products: These tempt investors with promises of some degree of principal protection in addition to a chance for higher returns, but there are drawbacks. One type of structured product links returns to the steepness of the yield curve. Investors may sign on because of high rates of fixed interest that aren’t, in fact, a permanent part of the deal. The numbers often convert to floating rates that change along with the yield curve. Also, these investments typically take longer to mature and could be illiquid on the secondary market. In addition, the issuer is in some cases able to “call” the investment and buy it back before it matures, leaving the investor with funds to invest at a much lower rate.
Leveraged Products: These use derivatives to allow investors to boost their yield in relation to a specific benchmark (one example is the so-called “leveraged ETF”). For example, these kinds of products might be designed to double the daily returns of the S&P 500, meaning that if the S&P rose by 2%, the leveraged ETF would go up 4%. There are also inverse leveraged products which seek to give investors the opposite yield of a certain benchmark or index. What investors often don’t understand is that in many cases these products “reset” their returns on a daily, not long term, basis. The yield on a yearly or even weekly measure might differ significantly from the performance of the specified index or benchmark during that same period of time.
Bond Mutual Funds and Exchange Traded Funds: The value of these investments is tied not only to interest rates but also to the number of other investors who choose to remain in the fund. If too many of them opt out, the fund manager could be forced to liquidate the holdings at a loss.
FINRA’s warning list includes other products such as preferred stock, hedge funds, private equity and reverse exchangeable securities.
In addition to the products described above, FINRA warns that buyers looking to up their yields should be on the lookout for deals that are simply fraudulent, including high-yield investment programs promoted by unlicensed marketers who often promise two things that never mix: safety along with unsustainable high rates of return. Many of these are simply Ponzi schemes.
If you’re considering a change in investments, FINRA suggests you should ask:
- What are the fine details of the way the investment works? In some cases, your returns might come in some form other than cash. The list of unpleasant surprises could include exit fees, loss of principal and a lack of liquidity.
- What are the costs and fees? Some of these investments come with a double whammy: higher costs in addition to greater risks. Hedge funds and structured products are among the high-cost options. Some of the costs are built into returns, making it hard for customers to see how much they’re paying.
- Can the issuer redeem the investment before it reaches maturity? When this happens, buyers often have trouble finding a similar investment with the same kind of rate.
- Is there fraud going on here? The answer is most likely “yes” if you’re being promised returns of 30 percent a year or more without taking any risk on losing principal. Always verify that you’re dealing with a licensed seller.
Details are important in making sure that promises of more don’t lead instead to less. “The grass isn’t always greener,” says FINRA in warning investors to take a hard look at chasing high returns.
Customers who’ve moved to higher risk investments without being fully informed of the risks or were sold products that were unsuitable for them may have cause for legal action. If you have already invested in a product that promised but has not delivered high yield with protection of principal, you may may be entitled to recover your losses.
Smiley Bishop & Porter LLP represents individual and institutional investors in securities arbitration and business litigation. The firm focuses on cases involving defrauded investors, suitability claims, and mismarketeted investment products. Smiley Bishop & Porter LLP is available for a free initial consultation. Please visit us at www.sbpllplaw.com to obtain additional information or call us at 770-829-3850 or toll-free (800) 697-4514.