Most investors equate the word “bond” with safety or, at the very least, they think an investment in a bond, be it municipal or corporate, is safer than an investment in equity. Unfortunately, this is only partially correct. While it is true that bondholders have a better chance of getting paid in the event of a bankruptcy than shareholders, there are many risks in bonds and it always pays to dig a little deeper.
When an investor buys a bond, the investor is lending money to someone (the government or a private company) who promises to pay back the money when the bond matures, plus interest. Whether a company defaults on its bonds or not depends on its ability to pay back its debt. The ability of the bond issuer to meet this obligation is expressed in the bond’s credit rating. Historically, bonds that had high credit ratings were known as investment-grade bonds, while bonds that had low credit ratings were known as non-investment grade or speculative bonds. Bonds are rated by ratings agencies, such as Standard & Poors, Moody’s and Fitch. The ratings can range from AAA (highly unlikely to default) to D (in default). Unfortunately, these ratings have come under serious scrutiny in recent years and are not as meaningful as they were in the past.
Bonds, like other investments, should be recommended by brokerage firms only when they reasonably believe the bonds are suitable for a given investor, given the investor’s investment objectives, risk tolerance, financial situation and needs, tax status, other security holdings, and other relevant information known by the broker. In addition, brokers are obligated to provide investors with balanced disclosures of all material facts – good and bad. Likewise, brokers have a duty not to omit to disclose material facts to a customer. Breach of these duties gives rise to legal rights.
Investing in bonds carries risks. These include, but are not limited to:
- Junk Bonds Junk bonds are bonds that are rated as “speculative” or “below investment grade” by the ratings agencies (below BBB by Standard & Poor’s and below Baa by Moody’s). Brokerage firms, when recommending junk bonds, will sometimes omit to disclose the highly speculative nature of these bonds; instead, firms choose to emphasize the higher yield these bonds pay.
- CDOs and Structured Products Many brokerage firms lumped Collateralized Debt Obligation (“CDOs”) and Structured Products (such as Principal Protected Notes) into the bond category, and sold them as such to unsuspecting investors. Over the last few years, the world has discovered just how speculative these investments really are. These investments were first intended for sophisticated, high net-worth investors such as hedge funds, pension plans and mutual funds. Brokerage firms then realized they could make even more commissions by selling these highly risky investments to the everyday investor. In the process, the firms omitted to disclose the many risks associated with these complex investments, which resulted in disastrous consequences. For instance, many investors lost all the money they invested in the Lehman Brothers Principal Protected Notes.
- Lack of Transparency The pricing of bonds is not an exact science and can involve complicated (and behind-the-scenes) machinations that are not known or understood by many investors. This is particularly true for the more esoteric investments such as CDOs. This makes it difficult for the average investor to know where they stand on any given day with their bond investments.
- Default Risk A bond is just a promise that the debt holder will be repaid at a specified date. As we know, corporations go bankrupt. Cities and states run into financial difficulty. All of this can result in default, and the bondholder losing some or all of their money. Default risk is also known as credit risk.
- Nonpayment of Interest Bonds are considered “fixed income” investments because they pay a fixed rate of return, which is the main reason most investors invest in bonds. If a bond’s payment is discontinued, many investors in that bond will be damaged.
- Interest Rate Risk Bonds generally pay a fixed interest rate. When market interest rates rise above a comparable interest rate being paid by a bond, the bond declines in value. When market interest rates fall below a comparable interest rate being paid by a bond, the bond increases in value.
- Liquidity Risk The market for bonds is generally thinner than that for stock. The reality is that when a bond goes for sale on the secondary market, there may not always be a buyer. If an investor should need to sell their bond, they may not be able to or may not be able to get a fair price.
Though the word bond implies a sense of safety, it is important for investors to remember that not all bonds are created equal.
If you have investment losses or problems involving bonds, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).