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Investors Are Chasing Yield at Their Own Peril

May 27, 2014 Blog

The Federal Reserve’s low interest rate policies have pushed investors pursuing returns, or “chasing yield” as it’s known on Wall Street, to buy riskier assets, including junk bonds and penny stocks.

Investors are piling into the riskiest corporate bonds, while others are plowing into incredibly risky shares of tiny publicly traded companies that dwell in the over-the-counter pick sheets, the dirtiest part of the stock market. These two parts of the market, junk bonds and microcap stocks, can turn on a dime, wiping out investors like a tornado ripping through the Midwest in springtime.

Are investors aware of the risks they are taking when they buy such assets to chase yields?

According to a recent Wall Street Journal article, investors have been snapping up corporate bonds with a rating known as “Triple-C”, a grade that analysts consider to be highly speculative.

Companies are issuing the junk debt to pay for buying another company, a corporate strategy that has repeatedly backfired in the past. Think of AOL buying Time Warner in 2000 at the height of the bubble, and you get the picture of the potential risks of such deals.

A recent example of investors chasing yield is the $1.3 billion 6.6% junk notes offered in the Ortho-Clinical Diagnostics deal. French cable company Numericable Group issued $10.9 billion in junk bonds to help fund its parent company’s acquisition of a French telecom company. That was a record sale that nearly doubled the previous biggest junk bond sale, according to the Journal’s Tom Lauricella and Katy Burne.

“The demand for low-rated debt is raising concerns that investors are stockpiling future risk,” one portfolio manager told the Journal. “Recent buyers could be hit when interest rates eventually rise – which would drive down bond prices.”

Investors need to look at their portfolio and see if they can stomach the risk of a possible default which is the flip side of the higher returns investors are now chasing. Investors tend to plow into markets at exactly the wrong time. The disaster scenario looming here is that Mom and Pop investors are plowing into junk bonds right when the market is expecting interest rates to rise.

Another Journal article recently reported that even Fannie Mae, which was bailed out by the U.S. Government in 2008, had a highly successful $1.6 billion offering of “risk–sharing certificates.” These certificates enlist investors to pay for a potential default on the home loans Fannie guarantees. The riskiest of these securities were linked to home loans where purchasers put down as little as a 3% down payment. According to the Journal, this offering drew 19 times the bids necessary to complete the sale.

“The latest place where investors are taking on more risk in exchange for apparently meager returns: the U.S. housing market,” wrote Al Yoon. “Robust investor demand for the deal is the latest sign of investors’ willingness to take on more risk in return for higher income amid soft economic growth and low interest rates on safe investments.”

That’s not all.

Investors are also “piling into the shares of small risky companies at the fastest clip on record, in search of investments that promise a chance of outsize returns,” according to yet another Journal article from last week, this by Tomi Kilgore. “The investors are buying up so-called penny stocks—shares of mostly tiny companies that aren’t listed on major U.S. exchanges—at a pace that far eclipses the tech boom of the late 1990s.”

“Those include firms that focus on areas from medical marijuana and biotechnology to fuel-cell development and precious-metals mining—industries that are perceived by some investors as carrying strong growth potential,” Kilgore wrote.

“Average monthly trading volume at OTC Markets Group Inc., which handles trading in shares that aren’t listed on the New York Stock Exchange or Nasdaq Stock Market, has risen 40% this year in dollar terms from a year ago, to a record $23.5 billion,” according to Kilgore. “The renewed interest in a market that used to be known as the pink sheets—because of the colored pieces of paper once used to record prices for unlisted stocks—shows investors are ramping up risk in a bid to boost returns as U.S. stock indexes are hovering near highs and stock valuations have risen above historical norms.”

Pink sheet stocks ooze risk. Larcenous stock promoters often use such tiny stocks to fleece investors by ramping up the company’s stock prices by touting recent, bogus achievements. Those can range from a biotechnology company making a new medical breakthrough or a mining company discovering a new vein of precious metal at a dig. Once the investing public starts to buy the stock, and drive its price up, the promoter dumps his shares and pockets his profits.

As this blog has previously noted, investors in Puerto Rico and elsewhere are holding billions of dollars of Puerto Rico municipal bonds which were downgraded to junk status in February 2014. The market value of these bonds plummeted last summer; the junk bonds and penny stocks that some investors are currently loading up on can similarly turn on a dime and potentially create massive, devastating losses.

At some point, likely when interest rates rise, investors’ skies will darken, storm winds will rise and funnel-like clouds will form on the horizon. It’s then that investors will regret their yield-chasing, junk bond and penny stock binge.

Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.