Securities Regulator Warns Against Chasing Higher Yield Through Risky Investments
FINRA (the Financial Industry Regulatory Authority) is concerned that the current low yield on traditional safe investments is causing investors to reach for higher yield, unfortunately through riskier investments. As a result, FINRA has issued an alert entitled, “The Grass Isn’t Always Greener – Chasing Return in a Challenging Investment Environment.” Let’s highlight the regulator’s key points.
Given that investment yields have been low (for example, a 10 year U.S. Treasury pays around 3 percent), FINRA reports a significant increase in investments that may carry greater risk, such as high yield bond funds, floating-rate loan funds and structured products. Those and other higher yielding investments are finding an audience. The problem, according to FINRA, is that the audience may not understand what they are buying, especially the features and the risks that accompany the possibly higher yield.
FINRA’s alert preliminarily discusses the five questions that investors must ask in considering any higher yielding investment. Those questions are, first: Does the higher return from the investment come with increased risk? FINRA answers, “Invariably the answer is yes.” That is because the “promise of higher return is almost always associated with greater risk and an increased possibility of investment losses.”
The second question to ask is: Do you understand how the investment operates? FINRA cautions, “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.”
Third, investors must ask: What are the costs and fees associated with the new investment? FINRA notes that some higher yielding investments have higher costs. As examples, FINRA states that “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.”
The fourth question to ask is: Is the product callable? A callable investment allows the issuer to redeem the investment prior to the investment’s reaching maturity. FINRA warns, “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.”
The fifth and final question is: Could the new investment be fraudulent? FINRA cautions that, “Legitimate investments that promise returns of 30, 50 or even 100 percent per year without any risk to your principal simply do not exist.”
While there are a “multitude of choices” for investors searching for higher yield, FINRA focuses upon the more common investments. The first one is high yield bonds. They are called “high yield” bonds because they are not “investment grade” bonds. Their lower credit rating (and higher propensity to default in making debt service payments) requires them to pay a higher yield to attract investors. FINRA reminds investors to be careful when investing in high yield bonds because of the “increased possibility that you could lose money on your investment.” Similar concerns exist with respect to high yield bond funds or Exchange Traded Funds (ETFs). In those investments, the value of the investment is affected not only by defaults of bond issuers, but also by prevailing interest rates and the willingness of fellow investors to remain in the fund. In other words, sales by some investors affect the value for all of the investors.
FINRA also discusses floating-rate loan funds, which invest in loans extended by financial institutions to entities below investment-grade credit quality. The higher interest rate paid (compared to safer investments) is adjusted upwards or downwards every 30, 60 or 90 days in light of the prevailing interest rate environment. FINRA identifies several concerns with floating-rate loans and funds that invest in them. Those concerns include the fact that the market for the loans is unregulated. Likewise, the loans do not trade on an exchange, are relatively illiquid and are difficult to value. Moreover, FINRA states, “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 products are yet another category investing in less than secure debt. Structured products generally are unsecured debt with payoffs linked to a variety of underlying assets. Investors especially must be on guard given the sales pitches associated with these products. While they are promoted as having some level of principal protection, FINRA cautions that “these products can have significant drawbacks such as credit risk, market risk, lack of liquidity and higher hidden costs”, in addition to the risk that they can be callable within a short period of time such as one year.
As one can see, the grass is not always greener when it comes to chasing higher yielding investments!