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Investors Chase Junk, Raise Suitability Issues
February 27, 2012
[ by Melanie Gretchen ]
It's no secret that fixed income securities have, over the past couple of years, thrown off miniscule yields. And with the Fed Chairman Bernanke promising to keep the fed fund rate at or near -0-% through 2014, the picture is unlikely to change dramatically.
With investors hungry for more interest income, it's not surprising to see investors shift their attention from traditional investments to "junk bonds." Year-to-date, junk or high-yield bonds have returned 4.74%, almost half of the 8.6% gain of the S&P 500-stock index. And such investments are available to retail investors through mutual funds. This year alone, investors have poured nearly $12 billion into junk-bond mutual funds - while stock funds have grown by $5 billion, and investment-grade bond funds have grown by $10 billion, according Lipper Analytical.
So What Gives: Past Differences. Junk bonds outperformed stocks (S&P 500) in 2011 - 5% versus 2% - while less that the 8% return for investment-grade corporate debt. It shouldn't surprise anyone if these investment trends simply reflect the common trait of retail investors to 'chase past performance.'
C-I Takeaways: The Suitability Risk. Brokerage firms should be weary, at best, about the latest developments. For one thing, it's likely that customers don't fully understand or appreciate the higher risk of default posed by companies rated as 'junk'. For those firm customers who insist on investing in junk bonds, but are the ones who can least afford losing their principal, firms might consider implementing some heightened compliance procedures - some of which are CYA in nature:
- Mark customer order tickets as "unsolicited" in those instances where the broker thinks 'junk' is unsuitable for particular customers.
- Have brokers provide customers with disclosures or documentation on the heightened risks of 'junk' bonds - before or at the time the purchase order is placed.
- Have supervisors or managers send out activity letters to customers who purchase junk bonds- via mutual funds, or the bonds themselves. Ask that customers acknowledge in writing that they understand the risks v. rewards of such investments and that, where applicable, the order had not been unsolicited by the person's broker.
Remember: When it comes to asking, 'What's in your customer's wallet?', look past today and focus on what they're likely to have 'tomorrow'. Having lost significant principal on what started out as a risky investment is what can inspire a customer to take his or her broker and firm to arbitration - seeking full restitution, coupled with damages. Some proactive steps can minimize the risks of the firm and its brokers.
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