Investment Fraud Lawyer Blog

Junk bonds have benefitted both investors and issuers over the past few years, providing borrowers with some of the lowest interest rates ever, while providing yield-hungry investors with better returns than they could receive by investing in investment grade debt. Junk bonds produce higher yields because of the increased risk of default by the issuer. “But investors run the risk of having the tide turn against them should interest rates start rising. Some analysts have begun suggesting that day could come soon” (“Junk Bonds Feed a Hungry Market,” by Matt Wirz, Wall Street Journal).

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The prospect of several more years of extremely low interest rates is causing people who depend on interest income to accept Wall Street’s recommendations to purchase relatively illiquid and opaque alternative investments like structured products, non-traded REITs, hedge funds and variable annuities. (“Itchy Investors Ramp Up the Risk,” Wall Street Journal). Regulators worry that the increased risks associated with such investments are not being explained to investors.

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Wall Street Journal columnist Jason Zweig is warning junk bond enthusiasts to think twice before investing in junk bonds, especially junk bond exchange traded funds. In addition to the junk bonds themselves being overbought, the exchange traded funds that own them trade at a premium over the net asset value of the junk bonds. When you add the expense ratio to the premium, investors are now paying 2 percent more than the current value of the bonds. All of this means that, if investors start to dump junk bonds, the ETFs will decline about three times more than the underlying bonds. “’Junk’ ETFs: Tread Lightly,” Wall Street Journal).

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There has been a marked uptick in purchases of high-yield or junk bonds by retail investors. Junk bonds pay a higher interest rate to compensate investors for the increased risks of default, among other risks. So far this year, retail investors are have put $11.8 billion into junk bond mutual funds, $9.9 billion into investment grade bond funds, and $4.8 billion into stock funds (See Wall Street Journal, “Buyers Take a Shine to ‘Junk’”). Mutual fund managers are also buying more junk bonds to enhance returns.

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Given the array of exotic alternative investments being sold to the public, it’s logical that many investors often don’t understand what they are buying. What is even scarier is that it is likely their professional investment adviser doesn’t understand the alternative investment either. Investment advisers – 75 percent of them – admit they do not understand alternative investments. Notwithstanding their puzzlement, 50 percent of advisers said they intend to increase their use of them in their clients’ accounts this year. They could use some help, however, because of alternative investments are so confusing. (“Alternatives spur anxiety,” InvestmentNews).

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Junk bond exchange traded funds have ten times more money than they did two years ago, and are causing some of the largest price swings ever. Junk bond price swings were seven times higher in November than in May. This volatility in the junk bond market is similar to the volatility seen in other asset classes caused by exchange traded funds. (See Bloomberg “Exchange Traded Junk Funds Roil Bond Market”).

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When world markets move significantly in apparent response to major macroeconomic news, even supposedly “uncorrelated assets” move in unison with them, according to Jason Zweig’s Wall Street Journal article, “Caging Raging Contagion.” Such a significant move occurred last week when the Italian government and bonds collapsed over its fiscal problems, and everything else fell, too.

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Many investors in alternative investments are in for unpleasant surprises. Alternative investments are very popular these days, as traditional stock and bond investments are not doing well. Alternative Investments include a wide variety of investments that fall outside the traditional stock and bond categories. Examples include structured products (such as principal protected notes and reverse convertibles); hedge funds; private equity; nontraded REITs; niche, leveraged, inverse leveraged, and synthetic exchange traded funds; and many others.

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Investors should use extreme caution before investing in alternative investments. Alternative investments have become the popular “investment du jour" but these investments are fraught with risks. Simply stated, alternative investments are not the panacea that so-called experts represent them to be. For the reasons discussed below, investors need to be very skeptical of any recommendation encouraging them to invest in alternative investments.

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The recent sell-off in the high yield bond market could mean an increase in bankruptcy filings as shaky companies that depend on that market find it is closed to them, according to Oleg Melentyev, head of high yield strategy at Bank of America. Despite the extremely low yields on traditionally safe investments such as certificates of deposit and money market funds, weak economic data, U.S. budget concerns, rising commodities prices, and, especially, a resurgence of Europe's sovereign debt problems sent many investors out off riskier asset classes like high yield bonds and into U.S. Treasuries.

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