Beware of "High Yield" Bonds
hese days investors need to worry about more than buying volatile technology and telecommunications stocks. The latest worry is (or should be) investing in "high yield" bonds. "High yield" is a euphemism for high risk, or a bond rating that is below investment grade.
Already, there has been a dramatic rise in securities arbitration case filings seeking to recover losses incurred on bond investments. Statistics at the largest arbitration forum, National Association of Securities Dealers (NASD) Dispute Resolution, show that investment loss claims involving corporate bonds jumped 40% in 2003. That was the highest increase among all categories, even higher than mutual funds and stocks.
Investors (and their lawyers) should understand that financial advisers have a duty to recommend bond purchases only after determining that there is a reasonable basis to recommend a particular bond, and that the bond is suitable for the particular investor. The financial adviser also has a duty to disclose to the investor all of the material risks associated with the bond recommendation.
Awards and Decisions
Arbitration awards and court decisions illustrate this point. For example, in a recent securities arbitration, the broker and his firm were held liable for recommending too large a purchase in the high yield bonds of Kmart. The arbitrators reasoned that it was inappropriate to recommend the investment of more than $50,000 in high yield bonds from a single issuer.
In another securities arbitration, five high yield bonds were found to be unsuitable for an elderly woman requiring income from conservative investments.
In a NASD disciplinary decision, a broker was fined and suspended for 60 days for various violations, including the unsuitable sale of "junk bonds" to an unsophisticated, retired investor of limited means. Delivery of the prospectus with written warnings did not cure the alleged oral misrepresentations that the bonds were safe and "guaranteed." Also unconvincing was the defense that the investor wanted to invest in the speculative securities.
Finally, a 1978 court decision sheds additional light. In this "Oldie but Goodie", a jury found (and the appeals court affirmed) that the bonds recommended to the investor were unsuitable and that the risks had not been adequately disclosed. The jury specifically faulted the financial adviser and his brokerage firm for not disclosing: 1) how the leading services rated the bonds; and 2) that the investor could not expect to acquire the annual income that she required unless she bought speculative securities involving great financial risk.
Special Caution
Another major problem with bond purchases is the lack of disclosure with respect to the markups charged to investors. Most bonds are traded over the counter. As a result, investors cannot easily determine their cost. Moreover, bonds that are riskier also tend to have higher markups. Notably, many times investors pay two markups, not one, because both the brokerage firm and the financial adviser have marked up the bond. Should a brokerage firm wish to encourage the sale of a particular bond, the firm can create an extra incentive for its financial advisers by increasing the markup.
Factors To Consider
Investors should not be lulled into a false sense of security upon hearing that, in 2003, high yield corporate bonds returned 28.1%. It is important to understand why high yield bonds did so well in 2003. The New York Times has reasoned: "The gain in total return came mostly from increases in the prices of these bonds as the rebound of the economy improved the credit outlook for the companies issuing them." Based upon these facts, investors must appreciate how difficult it is to predict whether the economy will continue to improve and, hence, not minimize the very real risks (default risk and price risk) associated with investing in high yield bonds. To put this disclosure in perspective, investors should not forget that in 2002, high yield bonds had a negative return of -1.9%.
Likewise, investors must understand bond ratings, and what they mean in practical terms. Start by knowing that "high yield" means "junk" and "non-investment grade". Then recognize the fact that the default rate for non-investment grade debt was 7.44% in 2002 and 5.68% in 2003 (through 11/23/03) according to Standard & Poors. According to FitchRatings, this decline in defaults has been due "overwhelmingly to a stabilization in some of the worst hit sectors of 2002, including telecommunication, banking and finance, utilities, and energy." Additionally, understand that, historically, certain sectors are more prone to default. Media and entertainment, telecommunications, consumer products and retail/restaurants are sectors that continue to show the highest vulnerability to default, according to Standard & Poors. Moving forward, investors must be prepared to stay informed about the status of the bond issuer, as well as any rating downgrades on the bonds themselves.
Finally, there is a fairly high correlation between the returns of junk bonds and stocks. The significance of this fact is that investors normally should not diversify an equities portfolio with junk bonds. Instead, consider using junk bonds to diversify an investment grade bond portfolio. Be careful not to overconcentrate in high yield bonds from a single issuer, like the investor in the Kmart case discussed above. If one's financial adviser cannot find a sufficient number of junk bonds to recommend, consider a high yield bond mutual fund or separately managed account.
In conclusion, be careful when investing in bonds because many are high risk. Investors should be able to avoid the rough waters that may lie ahead with junk bonds by following these tips.
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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