With investment grade bond yields at record lows, and likely to stay there for a while, stock brokers are recommending high-yield "junk bonds" to Mom and Pop investors searching for returns in this record low interest rate environment.
Remember, bond prices and their yields move in the opposite direction. So, with safe, stable U.S Treasuries in high demand, their yields are at record lows. This forces investors to chase yield, which means adding on risk which may or may not have been explained by their brokers.
The broad market has been whipsawed since the Brexit vote in Great Britain last week; the benchmark S&P 500 posted a decline of almost 4% from last Friday through late trading on Tuesday.
With Brexit hammering most investments, and the Federal Reserve likely to keep rates low, the lure of junk bonds paying 8% to 10% may be hard for investors to resist.
"Some investors are turning again to junk bonds, saying their higher yields make them a good bet at a time when many stocks and government bonds appear richly valued," according to a recent article in The Wall Street Journal by Sam Goldfarb. "The idea of buying into lower-rated companies with large debt loads at a time of general economic unease and acute concern about the U.K. departure from the European Union is anathema to many risk adverse investors."
The problem is most brokers are not discussing the high risk and speculative nature of such investments with their clients. Replay what Goldfarb wrote: "The idea of buying into lower-rated companies… is ANATHEMA to many risk adverse investors."
Are commission-hungry brokers adequately disclosing and discussing those risks when selling high-risk junk bonds to clients? Or are they only touting the potential returns? Discussing an investment's benefits without risk disclosure clearly runs afoul of investment fraud rules designed to protect brokers' clients.
There is no doubt that the allure at the moment of buying such junk bonds is powerful. For example, Sprint (NYSE:S) bonds due in 2020 are paying upwards of 11% returns. Similar bonds of other companies with distressed balance sheets are starting to sound awfully good to savers.
For Mom and Pop investors, caution is the word of the day when it comes to junk bonds.
Barron's writer Amey Stone underscores that conclusion in a blog from Tuesday. "Junk bonds have sold off in the wake of Brexit, but not enough to make them a buying opportunity," she writes, citing a strategist from the giant independent brokerage LPL Financial. "The average yield has climbed to 7.5% and the spread over Treasuries is at 6.4%, both of which might sound pretty appetizing."
But the strategist cautions investors to tread lightly in the junk bond market, which is tied to the distressed oil industry. "Considering year-to-date gains and valuations that are only fair in our opinion, recent weakness does not create a buying opportunity and the sector continues to have a tight correlation with oil, which poses a risk if dollar strength continues."
The old adage, "if it sounds too good to be true, it probably is," applies to junk bond pitches these days. Investors need to understand the correlation between risk and return. They need to beware of brokers bearing high-yield, junk bond gifts, which could blow up in the end.
Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.