Be leery of ‘bondlike’ claims of investment products

With clients desperately searching for yield, advisers need to be leery of the marketing claims associated with some fixed-income products, warns Bruce Kelly.

Financial advisers must remain wary of the claims of some funds and investment products that promise to be “bondlike” but fail to live up to that promise.

Advisers’ vigilance is particularly needed as investors grow skittish of bonds: The chief risk to bondholders and bond fund investors is the potential increase in interest rates.

Investors are turning to alternative investment products that promise attractive yields, and bondlike funds that are at times promoted as having the ability to preserve capital.

A Financial Industry Regulatory Authority Inc. case that dates back to the credit crisis highlights the confusion for advisers and investors when investing in these bondlike funds.

Independent broker-dealer Securities America Inc., for example, marketed notes issued by Medical Capital Holdings Inc. in the 2000s to advisers as “The missing piece that should be included in your fixed-income arsenal.” Medical Capital, in truth, was a $2.2 billion Ponzi scheme built on the back of phantom accounting of medical receivables and other investments.

Securities America clients invested about $700 million in the scheme.

Finra this year fined two broker-dealers affiliated with The Hartford Financial Services Group Inc. $100,000 for promoting a mutual fund in a brochure that made “unwarranted” and “misleading” statements in light of changing conditions to the bank loan market in 2008 and 2009. The fund in question is the Hartford Floating Rate Fund (HFLAX), which has $6.5 billion in assets.

“MISLEADING STATEMENTS’

“In particular, the brochure contained misleading statements that the mutual fund was appropriate for bond investors concerned about the price stability of their investments, provided the potential for greater price stability compared with other fixed-income investments and was appropriate for investors seeking some degree of capital preservation,” according to Finra’s listing of its April disciplinary actions. “Given the conditions in the bank loan market during the relevant period, these statements were not accurate.”

The two broker-dealers, Hartford Investment Financial Services LLC and Hartford Life Distributors LLC, now called Forethought Distributors LLC, in January signed letters of acceptance, waiver and consent over the matter. The two firms consented to the settlement without admitting or denying Finra’s findings.

In its annual regulatory and examination priorities letter issued in January, Finra focused on leveraged-loan funds, a particularly hot investment product at the moment. Finra warned that leveraged-loan funds, which saw relatively heavy inflows in 2012, may be touted as less sensitive to interest rate movements but do carry heavy risks.

Assets under management of loan mutual funds at the end of last month reached a record $110.6 billion, according to leveragedloan.com.

Last week, Morningstar Inc. reported heavy inflows of investor money to bank loan mutual funds, with $15.1 billion in inflows in the first quarter.

“Within the taxable-bond asset class, the bank loan, short-term-bond and nontraditional-bond categories had strong inflows, while the inflation-protected and short-, intermediate- and long-term government categories had outflows,” Morningstar reported last Wednesday. “This suggests that investors were shifting into more-credit-sensitive but higher-yielding segments.”

Advisers must be made aware of the risks of such funds, according to Finra. Leveraged loans are adjustable-rate loans extended by financial institutions to companies of low credit quality that have a high amount of debt relative to equity.

FLOATING-RATE LOANS

“Unlike traditional fixed-income bonds, floating-rate loans do not trade on an organized exchange, making them relatively illiquid and difficult to value,” according to Finra. “Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, but the underlying loans held in the fund are subject to significant credit, valuation and liquidity risks that may not be transparent to investors.”

Of course, investment products such as private placements, including the phony Medical Capital notes, and Investment Company Act of 1940 mutual funds investing in leveraged loans face much different levels of disclosure. Private placements make no disclosure about their holdings, while mutual funds are required to reveal what they own.

Regardless, investors are chasing yield and, at the same time, expecting to park money in a relatively safe spot. And they expect their financial adviser to have some answers and ideas for them.

This is a conundrum. Before selling such loan funds and other products that promise bondlike features, financial advisers have to examine and understand the credit quality and risks of the underlying loans and investments.

In other words, advisers must get their hands dirty and look under the hood of such products when selecting bondlike funds for their clients. That way, they can know how bondlike bondlike products really are.