Promise of Higher Returns Always Means More Risk

by Aaron Snellenbarger

The potential for a swing in what has become a gigantic bond bubble due to the decline in interest rates since the mid-1980s is slowly coming to an end. On the edges of this change, previously conservative investors have been pushed toward riskier investments in search of higher interest payments. The riskier investments have often times been junk bonds and risky private placements. Investors have chosen junk bonds for two reasons: 1) higher interest payments to supplement income; and 2) the misguided conception that because the investment is a bond, it is not as risky.

Interest rates have not been as low as they are now since the 1950s. For investors, most importantly retirees living off interest, this means that interest payments on investment-grade fixed-income investments are also at an all-time low. Retirees using these investments to supplement their income have seen their incomes greatly diminished, often resorting to more exotic forms of investment in search for higher returns to supplement their income. Forms of exotic investments include below-investment-grade bonds, normally referred to as junk bonds, and private placements. However, many investors have been confused by the specifics of these investments.

Junk bonds refer to bonds with less than a BB rating on the Standard & Poor scale. Although these bonds carry the same rights as normal securitized debt in bankruptcy, they have much greater risk associated with them, normally due to either the industry or business plan associated with the debt offering. The risk is that the funds raised through the debt offering will be invested in a company or project that does not generate enough return to pay back the loan from the bond purchasers. Furthermore, solely because a company has a reputable name does not mean that the bond carries any less risk than other bonds with a similar rating. Junk bonds may have a similar amount of risk as stocks of the same company without the upside for potential growth.

There is also a more general risk to investing in bonds in the current market. The benefit to bond investors in future interest payments carries an inverse relationship to interest rates. An easy example is a home mortgage. An individual would want to take out a mortgage or refinance a mortgage when interest rates are low because money is cheap. But, the bank, the investor in this example, would not receive as much return on the mortgage when the interest rates are low. A consequence of interest rates being so low is that they only have one direction to go, which is up. With an increase in interest rates in the future, the price of previously issued bonds will decrease as investors are able to purchase new bonds paying higher interest rates. Thus, an investor seeking to sell her bond would have to sell at a discount.

Investors should also be aware of the risks associated with investments in private placements. Even savvy investors are coaxed into these investments for the same reasons investors buy junk bonds: the potential for substantial returns. Just like all other investments that promise high returns, the amount of risk is directly proportionate. In general, investors should give careful consideration to a company’s management and capitalization before investing in a private placement.