The Risks of Chasing Yield

A large number of seniors and retirees depend upon the interest  paid by their bank or broker, every month, or every quarter, to pay their bills. Interest rates paid by banks on savings accounts has been under 5% for a number of years. Government and corporate bonds and bond funds haven’t paid much better.

So it should be no surprise that any number of financial sharks would prey upon seniors, offering higher interest, but often disguising the higher risks.

Many seniors buy and hold bonds or other fixed income instruments.  Bonds issued by the US Government, or by the states and municipalities of the United States are generally believed to be safe investments.  Because they are considered safe, they don’t pay much more interest than a savings account or CD at a bank.

The general rule is the more interest a bond pays the higher the risk.  What risk? The risk that the company will have difficulty paying the interest or will not be able to pay back the face value of the bond when it matures in the future. 

The best way to evaluate bonds is by their rating.  The higher rated bonds are the safest but pay the least.  Bonds rated slightly lower will generally pay a little more.

Junk bonds pay the most, but are rated the lowest, which means they pose the greatest risk to your money.  Make no mistake, some junk bonds do default, every year.  If a bond you hold defaults, interest payments will stop and you may lose all or part of your principal.

Mutual funds that call themselves “high yield” frequently have portfolios full of junk bonds.  Many of the largest high yield bond funds have had some bonds that have actually defaulted and others that came very close.  The theory is that the higher interest compensates for the additional risk.   That’s fine, if you want the risk. 
 
There are also special risks involving bonds issued in other countries.  This is not to suggest that every company located in a foreign country is suspect for paying off its bonds, but the international markets have special risks including currency fluctuations, that may not seem obvious to every investor. 

Many retirees are induced to buy limited partnerships or similar investments with the promise of a check every month or every quarter.  But be careful.  In many limited partnerships, especially those involving equipment leasing, investors frequently get some of their own money back with each check.   The result can be a nice check for 10 years, only to find that you have nothing left.

Fraud involving private promissory notes is already a serious problem and it is growing.  These investments may sound safe and easy to understand, but many of these note offerings are simply not legitimate. 

Deceptive promissory note programs are often sold with the following deceptive statements: 1) investors would receive very high, double digit returns, 2) returns were guaranteed, and 3) the notes were backed by collateral to guarantee them.

A corporate note offering will usually be registered with the state in which the notes are sold, or will be exempt from registration because the notes are only being sold to sophisticated investors who 1) can afford to lose the money they are investing, and who 2) have the expertise and information to determine if the investment is a good one.  More frequently, legitimate corporate notes are sold to banks and other financial institutions or to other corporations.

Even legitimate promissory notes involve risks — the company issuing them may have problems, such as competition, bad management, or severe market conditions, that may make it impossible for the company to carry out its promise to pay interest and principal to note buyers.

And these notes are usually not liquid, that is, they can’t be easily sold if bad news starts come out about the company that issued them.

Most of the large stock brokerage firms do not sell these types of notes to individual customers.  More frequently, these notes are sold by life insurance agents, tax preparers, and others who are not necessarily financial professionals.  They may not have the wherewithal to thoroughly investigate the company issuing the notes.  Sales commissions for these notes tend to be very high, and they are not always disclosed to potential customers.  

Promissory note schemes frequently target the elderly and their retirement savings.  If you can’t afford to lose your investment, you shouldn’t invest in private promissory notes.  It is really that simple.

Remember: If you are getting more than an average yield on any investment, you are generally accepting more risk than average, as well.   If the person who sold you the investment didn’t tell you that, fire them.