Investor Alert: A Closer Look at Junk Bonds, Floating-Rate Loan Funds, Structured Products, and Leveraged Products

by Wall Street Fraud on August 2, 2011

Stock broker fraud attorneyIn yesterday’s post, we highlighted the most recent Investor Alert issued by the Financial Industry Regulatory Authority (FINRA). The alert warns investors about chasing high returns in riskier investment products.

Today, we will take a look at each of the product highlighted by FINRA and its associated risks. While all investors want to get the highest possible returns from their investments, it is important to recognize that not all products are suitable for all investors.

High-yield bonds: These types of bonds have lower credit ratings, higher risk of default, and consequently a more favorable interest rate, which is designed to compensate the investor for the additional risk. While high-yield bonds are suitable in many portfolios, investors must understand that the higher yield often goes hand in hand with a higher possibility of losing your initial investment.

Floating-rate loan funds: These products invest in loans that financial institutions extend to entities of below investment-grade credit quality. Companies that are given these high interest rate loans usually have a high debt-to-equity ratio, and the returns on the loans are generally higher than investment-grade bonds. As the name suggests, interest rates on floating-rate loans adjust by a pre-determined spread over a reference rate, like the London Interbank Offered Rate (LIBOR). These products may be attractive in times of low or rising interest rates because, in addition to having higher yields, the fund's interest rate increases when rates rise.

However, the products also carry several risks. The market for floating-rate loans is largely unregulated, and since the loans do not trade on an organized exchange, they are relatively illiquid and difficult to value. 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 retail products: These are typically unsecured debt with payoffs linked to a variety of underlying assets. These products can seem attractive to investors because they can offer higher returns and might even feature a level of principal protection, subject to the credit worthiness of the issuer. However, these products can also have significant disadvantages such as credit risk, market risk, lack of liquidity, and high hidden costs.

Leveraged products: These products, including ETFs and mutual funds, seek to deliver multiples of a specified benchmark by increasing exposure to the benchmark through the use of derivatives. Leveraged products often "reset" daily, meaning that they are designed to achieve their stated objectives on a daily basis. Investors should understand that their performance over longer periods of time could differ significantly from the performance of their underlying index or benchmark.

Source: FINRA

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