Investors should be wary of investment professionals offering higher yields presented as low risk investments. Due to historically low interest rates (10 year U.S. treasuries recently traded as low as 1.99%), investors seeking income are now routinely offered non-traditional ways to achieve higher income returns. However, these non-traditional investment ideas often fail to have the requisite disclosures regarding the potential risk of loss in such an investment. Investors are being offered proposals from investment professional that include: purchases of income producing stocks, foreign bonds, reverse convertibles, or REITS.
Investment professionals proposing portfolios of income producing stocks should be making significant risk disclosures. Because a stock pays a dividend doesn’t provide any protection to investors beyond the income received from the underlying company. Dividend paying stocks are still subject to market and sector risks. Also, stocks paying substantial yields to shareholders always have the option of cutting the dividend, which will likely cause further price decline.
Over the past year, various European countries have come under significant market pressure, forcing yields to rise in countries such as Ireland, Portugal, Italy, Spain, and Greece. Higher yields come with significant risk disclosure requirements such as credit risk, and price risk for investors. Investors need to be warned that a bond yielding 5 percent versus 2.5 percent represents largely uncompensated risks, particularly if the issuer defaults. Recommending an investment yielding 2 percent more than a highly rated investment, where an investor can lose 100 percent of principal is reckless.
Investors, particularly seniors should run from any investment professional recommending reverse convertibles. These investments are too complex for retail investors. In exchange for an above market yield, investors may receive significantly less than their original investment back. Upside potential for such a recommendation is capped at whatever the yield is, and that yield is only for a very limited duration. Most investment professionals don’t have the sophistication to understand reverse convertibles, let alone make adequate risk disclosures to investors to sell them.
Investment professionals are also offering significant returns through REITS. While REITS pay significantly more than CD’s or high grade bonds, REITS possess substantial risks that the underlying issuer will not have the cash flow necessary to maintain payment of the above average yields. More often than not, income payments will stop altogether, and investors will have difficulty selling their REITS. Most REITS do not trade on national exchanges, and are subject to significant liquidity risks.
When it comes to higher returns, there is no free lunch. Slightly higher returns are not worth significant risks to an investor’s principal.