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Yield-starved investors beware: the high returns promised by complex new products might just be the latest version of the familiar old saying that goes, “If it sounds too good to be true, it is.”
With yields on fixed-income investments at historic lows and ongoing volatility in the stock market, the Financial Industry Regulatory Authority (FINRA) on Monday issued an Investor Alert—The Grass Isn't Always Greener: Chasing Return in a Challenging Investment Environment—that warns investors about putting their assets into risky and complex products that promise higher returns than more traditional investments.
High-yield, or junk, bond funds; floating-rate loan funds; structured notes with principal protection; and leveraged products are typical investments that people desperate for higher returns may be tempted to put their money into, says FINRA, which sent out the alert after seeing significant recent inflows into such investments.
High-yield bond funds had $75 billion in new sales in 2010, according to FINRA, while floating-rate funds grew from $15 billion in 2008 to $60 billion in April 2011, and sales of structured products increased from $33 billion in 2009 to $54 billion in 2010.
"Investors should never make an investing decision solely by looking at an investment's return, whether past or projected. Higher returns come with higher risk. Investors should always look behind an investment's yield, ensure that they understand how the investment works and carefully consider its fees and risks before investing," said Gerri Walsh, FINRA's vice president for investor education.
Junk bonds are bonds with lower credit ratings, higher risk of default and a more attractive interest rate to compensate the investor for the additional risk. “While high-yield bonds can make sense in many portfolios, the higher yield may come with an increased possibility of losing money,” FINRA warns.
Floating-rate loan funds invest in loans extended by financial institutions to entities of below investment-grade credit quality. Companies that are extended these high interest rate loans usually have a high debt-to-equity ratio, and those loans' yields tend to be higher than investment-grade bonds.
Structured retail products are typically unsecured debt with payoffs linked to a variety of underlying assets. These products can offer higher returns and might even feature a level of principal protection, but they can also have significant drawbacks such as credit risk, market risk, lack of liquidity and high hidden costs.
Leveraged products include exchange-traded funds and mutual funds that seek to deliver multiples of a specified benchmark by increasing exposure to the benchmark through the use of derivatives. Leveraged products often reset daily, and their performance over longer periods can differ significantly from the performance of their underlying index or benchmark.