Category Archives: Bond Losses

A Sept. 1 article titled “Ignorance Is Not Bliss” by Investment News highlights the impending issues facing bond investors  and whether financial advisers are taking appropriate measures to ensure their clients don’t get caught unaware.

Last week, the 10-year U.S. Treasury note yield was 2.78%, slightly down from 2.94% that it stood on Aug. 24. As the article points out, the yield pullback is likely to be short-lived as the Federal Reserve begins to taper its monthly bond purchases under what’s known as its five-year-long quantitative-easing program.

And that’s expected to happen very soon, which means investors need to take careful note. Because bond prices move in the opposite direction of yields, the rise in market yields could spell huge losses for investors. This is especially true for bond mutual funds in which portfolio managers are forced to sell their holdings at a loss in order to meet redemption demands, according to the Investment News article.

The article makes it very clear:  The yield on the 10-year Treasury has gained a full percentage point since mid-May. A 1-percentage-point rise in interest rates translates into about a 1% decline in prices for every year of a bond’s duration. To put it another way, a bond fund with a 10-year duration would fall in value by 10% for every 1-percentage point interest-rate rise.

The question becomes whether investors clearly understand the impact of rising interest rates on their investment portfolio. Unfortunately, several studies indicate that the answer may be “no.”  According to a new study by brokerage firm Edward Jones, 63% of Americans don’t know how rising interest rates will affect their retirement portfolios, including their 401(k)s and IRAs. Moreover, 24% say they feel completely in the dark about what rising interest rates actually mean.

Financial advisers should be paying attention and taking steps to make sure their clients understand the current financial climate, especially the impact of rising interest rates on bonds. In some cases, that’s happening. In other instances, advisers appear to be completely out of touch with the state of the bond market. In that scenario, investors could very well be caught off guard and pay the ultimate price.

“The biggest risks to the clients is the adviser being either oblivious or in denial about how bonds work. And the client has faith in the adviser . . . High-quality bond funds are the worst investments on the planet right now,” said Robert Isbitts, founder and chief investment strategist at Sungarden Investment Research, in an Aug. 27 interview with Investment News.

Investors who are planning to invest in municipal bonds need to do their homework; if not, they may unknowingly give their first year’s worth of income to their broker. A June 7 article by the Wall Street Journal sheds a spotlight on the murky world of today’s municipal bond market – and what investors can and should do to minimize their risks and maximize their net returns.

As the article points out, “yields on the highest-quality, widely traded munis, triple-A-rated, 10-year “general obligation” bonds have risen by 0.45 percentage point since May 1.  And while U.S. Treasury yields also have risen recently, muni yields have truly skyrocketed.”

But before jumping on the municipal bond bandwagon, investors should proceed with caution,  industry experts say. Unlike what happens with stocks, you don’t pay a commission when buying a municipal bond. Rather, you pay a “markup,” which is the difference between a broker’s cost and the price an investor pays.

The markups themselves can be astronomical. And, unfortunately, most brokers don’t disclose their markup. Regulators and market analysts agree that many retail investors have no idea how much they’re getting charged on muni trades.

Securities Litigation and Consulting Group, a research firm in Fairfax, Va., recently analyzed nearly 14 million trades of long-term, fixed-rate munis over a period between 2005 and April 2013. (You can review the SLCG report here.)

The study found that on one out of 20 trades, people who bought $250,000 or less in municipal bonds paid a markup of at least 3.04%, or approximately a full year’s worth of interest income at today’s rates. By comparison, you will pay less than $10 in commission to buy a stock at most online brokers, or 0.004% on a $250,000 purchase; a typical mutual fund charges management fees of about 1% a year.

SLCG founder Craig McCann estimates that investors paid at least $10 billion in what he considers excessive markups since 2005. That is at least twice the normal cost to trade a given bond.

“That’s more than a billion dollars a year needlessly transferred from investors to dealers’ pockets,” McCann said in the Wall Street Journal story.

Investors in some states have a lot to learn when it comes to investing and financial literacy, says a recent study by the Financial Industry Regulatory Authority (FINRA).

According to the study, residents of California, Massachusetts and New Jersey are the best at handling their money. By comparison, individuals in Mississippi, Arkansas and Kentucky rank at the bottom of the list.

“This survey reveals that many Americans continue to struggle to make ends meet, plan ahead and make sound financial decisions – and that financial literacy levels remain low, especially among our youngest workers. No matter how you slice and dice it, this rich, new data set underscores the need for us to continue to explore innovative ways to build financial capability among consumers,” said FINRA Foundation Chairman Richard Ketchum.

Overall, the number of respondents demonstrating a high degree of financial literacy – meaning they correctly answered four or five of the five questions about financial knowledge – dropped to 38% in 2012, from 42% in 2009.

About half of survey respondents said they worked with a financial professional in the past five years. However, they still lacked knowledge of key financial market concepts, the study found.

For example, only 28% correctly answered a question about the movement of bond prices, compared with interest rates. Less than half correctly answered a question about the risk of a single company stock versus a diversified mutual fund.

Study responses were collected through an online survey of 25,509 American adults (approximately 500 per state, plus D.C.), over a four-month period from July to October 2012. The sample used in the study was weighted by age, gender, ethnicity and education. The full data set, questionnaire and methodology are available here.

Investors with so-called safe bond funds in their portfolio could be in for a surprise. Last week, the Financial Industry Regulatory Authority (FINRA) issued a notice warning investors that in the event of rising interest rates, outstanding bonds with a low interest rate and high duration may experience significant price drops.

“With interest rates hovering near all-time lows, investors should make sure they know their duration numbers,” said Gerri Walsh, FINRA Vice President of Investor Education.

As explained in FINRA’s alert, a bond fund with a 10-year duration will decrease in value by 10% if interest rates rise 1%. In contrast, if a fund’s duration is two years, then a similar 1% rise in interest rates will result in only a 2% decline in the bond fund’s value.

FINRA urged Investors to keep in mind that just because a bond or bond fund’s duration is low, it does not mean the investment is risk-free. In addition to duration risks, bonds and bond funds are subject to inflation, call, default and other risk factors.

To find your bond fund’s duration, investors can look on the fund’s fact sheet. Investors holding individual bonds should start by asking their investment professional or the bond’s issuer, FINRA’s alert said.

Got short-term bonds? For a growing number of investors, the answer is “yes.” And that could be a problem in the making.

As reported Dec. 28 by the Wall Street Journal, more short-term bond funds are loading up on riskier securities lately. The 95 short-term bond funds tracked by Morningstar have increased their average exposure to high-yield “junk” bonds – as well as other securities rated below investment grade – to 6.4% of total assets this year from 5.8% in 2009 and 3.7% in 2008.

One warning sign regarding short-term bonds concerns the annual yield and if it is much greater than the category’s average of 2%, according to the WSJ article. Generally, funds yielding more than double that amount are likely to have a higher exposure to lower-grade investments.

During the 2008  financial crisis, several short-term bond funds that had previously been posting good returns but held large positions in bonds with poor credit quality suffered as much as a 25% drop in value as a result of the economic downturn, said Craig McCann, president of the Securities Litigation & Consulting Group, in the Wall Street Journal story.

“The highest-performing funds are also the most risky ones,” McCann said. “It just might not be apparent to investors right away.”

Experts advise investors to do their homework before investing in short-term funds – and that means thoroughly researching a fund’s holdings, investigating the fund’s marketing literature and even reviewing filings with the Securities and Exchange Commission (SEC).

One key piece of information to know concerns the yield and from where it is coming. Like many investments, if it’s too good to be true, it probably is.

Says the WSJ story: “If a fund does have a large position in higher-yielding or lower-rated securities, investors should make sure they know which individual bonds the fund is buying – as well as its total exposure to each type of bond and its rating – before determining whether the risk is manageable.”

A New York arbitration panel of the Financial Industry Regulatory Authority (FINRA) has ordered Citigroup Global Markets, Inc. to pay compensatory damages of more than $1.4 million to an investor who suffered losses tied to a municipal bond fund that was marketed as safe and secure but in reality contained risky derivative securities.

The investor purchased Citi’s Rochester Municipal Fund in 2007 after Citigroup recommended it as a safe alternative to her municipal bond fund investments and one that would pay slightly more interest. Instead, the Rochester Municipal Fund consisted mainly of toxic and speculative derivative securities whose value is dependent on the performance of underlying assets.

“Through the issuance of this arbitration award, our client not only received a substantial portion of the losses that she sustained as a result of her investment in the Rochester Municipal Fund, but the arbitrators also further held Citigroup liable for 9% of statutory interest on her principal loss, as well,” says Maddox Hargett & Caruso’s Steven B. Caruso, who served as counsel for the investor.

The case shines an important spotlight on the questionable sales practices of brokers and the impact those practices can have on investors regardless of their wealth or financial sophistication.

“Wealthy investors in particular are often asked to defend their investment choices by brokerage lawyers in arbitration cases, because of the false assumption that they must have a deeper understanding of what they are buying than average investors, said Caruso in a Sept. 12 article by Reuters. “Wall Street often mistakenly equates wealth with financial know-how.”

In addition to this FINRA arbitration award, Maddox Hargett & Caruso, P.C. has served as co-counsel in numerous other FINRA arbitration proceedings involving Citigroup’s ASTA-MAT municipal arbitrage products. To date, investors in those cases have been awarded damages of more than $60 million.

Since the end of April, when the stock market began to fall, investors have withdrawn about $75 billion from U.S. equity funds. At the same time, they’ve put about $42 billion into bond funds.  Why? Because they perceive them to be safer than the stock market.

But beware. Some of these bond funds contain huge investments in junk bonds that, in turn, can blow up under certain circumstances. Moreover, all of these funds will drop once interest rates rise. It may take a few years, but make no mistake – they eventually will drop. And as we’ve witnessed in the past, the junk will rise to the top.

Investors’ once-safe bond funds may not be so safe anymore. That’s because the research firms responsible for assessing the safety of bonds have changed their methodology as of Sept. 1. For many investors, the move means that the investment-grade bond fund they thought they were investing in could now have a credit risk similar to a junk-bond fund.

Before the change, research firms like Morningstar determined the safety of bond funds on the credit ratings issued by rating agencies like Moody’s or Standard and Poor’s. The new methodology is based on default risk.

As reported Sept. 27 by the Wall Street Journal, more than half of the domestic taxable bond funds tracked by Morningstar saw their average credit-quality ratings fall under the new methodology. About 43% of bond funds fell by one credit grade and about 13% dropped by two credit grades, according to the Wall Street Journal article.

Several bond funds, including Federated Real Return Bond Fund, Cavanal Hill Intermediate Bond Fund, Neuberger Berman Short Duration Bond Fund and TCW Short Term Bond Fund, dropped by even more. In some instances, the funds fell to non-investment-grade ratings, such as BB, from investment-grade ratings of AA.

The new methodology comes on the heels of research from Securities Litigation & Consulting Group, a consulting firm that provides expert witnesses to regulators, law firms, banks and brokerages. The company’s study, published in November 2009, revealed that the mutual fund industry often reported average credit-quality ratings that were at least one whole letter credit-rating higher than the portfolios’ true credit risk.

According to Craig McCann, one of the study’s authors, Morningstar’s change is likely to “have a significant impact on bond portfolios that spread out their credit quality.”

In May and June, investors prevailed in five out of six arbitration claims against Memphis brokerage firm Morgan Keegan. Meanwhile, hundreds of additional individual arbitration claims await decisions from the Financial Industry Regulatory Authority (FINRA).

Since 2008, thousands of investors have suffered more than $1 billion in losses from a group of mortgage-related Morgan Keegan bond funds. The funds, whose investments were tied to the real estate market, plummeted by as much as 80% following the burst of the housing bubble.

In the lawsuits and arbitration claims that have followed, investors accuse Morgan Keegan of misrepresenting or failing to disclose certain facts about their investments.

In April 2010, regulators charged Morgan Keegan and two employees with fraud for inflating the value of mortgage securities and other risky debt held in the bond funds at the center of the ongoing litigation. The complaint – which was filed by the Securities and Exchange Commission (SEC), FINRA and various state securities regulators – also charged Morgan Keegan portfolio manager James Kelsoe of improperly directing his accounting department to make repeated, arbitrary “price adjustments” that boosted the fair values of securities.

Morgan Keegan’s Joseph Thompson Weller, who led the accounting department, is named in the complaint, as well.

Morgan Keegan’s legal problems show no signs of letting up. The latest troubles facing the Memphis-based investment firm include federal and state charges alleging Morgan Keegan and two employees – James Kelsoe and Thomas Weller – committed fraud when pricing several proprietary bond funds.

As reported April 12 by the Wall Street Journal, the federal and state charges are in addition to a slew of arbitration claims filed by investors who allegedly lost approximately $2 billion through fraudulent and reckless business practices on the part of Morgan Keegan. Class-action lawsuits also have been leveled against the company.

Mississippi, Alabama, Kentucky and South Carolina regulators joined the Financial Industry Regulatory Authority (FINRA) in filing fraud charges on April 7. The Securities and Exchange Commission (SEC) filed similar charges that same day.

The fraud charges are “a serious event,” said Chris Marinac, managing principal at FIG Partners, in the Wall Street Journal story. “The exposure” to eventual costs “could be all over the map,” he said. “There’s no telling what a judge and jury will do.”

Morgan Keegan may also have another legal problem on its plate. The SEC reportedly could force the company to buy back nearly $200 million in auction-rate securities – investments that became frozen when the credit markets seized up in February 2008.