In the recent years, we witnessed a sharp decline in Puerto Rican municipal bond prices and related assets, resulting in an upsurge in FINRA claims, arbitrations and awards. This has revealed new insights into the bond market and we anticipate a wave of FINRA Arbitration cases linked to bonds and fixed income asset classes.
After the recession in 2008, there has been a massive movement away from equities towards the seemingly less-risky and volatile asset class of bonds, creating a spike in demand for U.S. treasuries, corporate and municipal bonds. More than $1 trillion has flowed into the U.S. bond market since 2008.
Bonds are sensitive to interest rates and it’s pricing inversely proportional to interest rates. Fed has explicitly stated their intent to hike interest rates going forward, therefore, a fall in bond prices can be reasonably anticipated. Rising interest rates will result in losses for bond investors, most immediate effect being paper losses, and the inability to sell those bonds without incurring actual losses for a long time. Majority of the impact will be felt by longer term bond investors with 10 years or more to maturity and by non-treasury bond holders that tend to fall faster as rates rise.
It is quite common for investors to not have adequate information to comprehend the losses in bonds, bond funds and fixed-income assets that they invest in. In the recent experience with Puerto Rican funds, it became evident that investors were caught off guard, having not anticipated or been informed about the risks associated with bonds. The losses are frequently unforeseen by both investors and fund managers and investment advisors.
So what risks are facing bond investors and how are they being potentially blindsided by investment banks and brokers?
Suitability and Risk Disclosure
Bonds are thought to be and often effectively are a safe haven for conservative investors, but increasingly some bonds have become far more complex today. Dealer banks and brokers often do not communicate the risks involved in more complex offerings to their clients. It is perceived to be a more stable class of investment, but bond financing contains several underlying risk factors, both systemic and unsystemic. Some client facing brokers are not trained well enough to understand the risks themselves. Volatility of bonds are often determined by yield to maturity, duration, and changing policies. Concepts like these should be explained well to investors and their risk appetite and circumstance in life prioritized at the time of investing.
Limited Liquidity
Since 2007, bond holders are unable to liquidate their bonds as quickly as they once did. Dodd-Frank limits the capacity of dealers in terms of how much bond inventory they can hold. Since the implementation of Dodd-Frank, the liquidity has changed dramatically for the bond market but brokers seldom explain this to their clients. Other factors have contributed to this liquidity crunch. Last year, the Feds leveled off their bond buy-back program. The market has been inundated with corporate bonds and treasuries, and investment banks have fed the appetite for new bond issues voraciously since 2008. Supply easily overwhelms available liquidity. In the current environment, bond sellers do not get bids from dealers as easily as they once could. When the bond market goes down, and prices fall, investors might be forced to liquidate and could face an impossible situation where they cannot sell. But are brokers communicating this effectively?
There is a lot of margin buying of fixed income securities and in case where the bond market becomes illiquid, there is a potential for wide spread panic with margin calls and large sell-outs.
Investors should be wary of advice they receive about investing in bonds and bond funds and assess the risks facing them. The attorneys at Malecki Law have represented several individuals who lost their investments due to unsuitable investment recommendations or omission of risks by financial advisors/ stock brokers.