Attractive Yields and Hidden Risks

The Wall Street Journal had a great piece this weekend concerning the investments some investors are seeking out to find yield in this low interest rate environment. Investors are taking on more and more risk to realize the yield they once found commonplace and this article brings a few examples to the forefront.

The risk investors are taking include credit risk (high-yield/junk bonds), market risk (closed-end funds trading at a premium) or some combination of the two (structured products). Structured products in particular are complex debt securities that expose investors to the credit risk of the issuing bank and -- in a usually less-than-straightforward-way -- expose investors to the underlying/linked asset or index. From the article:

When the notes go wrong, they go very wrong, says Craig McCann, founder of Securities Litigation & Consulting Group, a Fairfax, Va., consulting firm specializing in structured products. One note linked to Netflix and issued by J.P. Morgan promised an annualized yield of 21%, yet investors lost 35% after Netflix's shares dropped to $70.22 on May 25, from $109.41 on Feb. 27.

According to the research report of this particular reverse convertible, investors in these notes experienced an annualized rate of return of nearly -80%. So although the annualized yield of 21% may have been attractive initially, Netflix depreciated considerably during the term of the notes and -- as a result of this market exposure -- investors experienced heavy losses.

The lesson is that if you're being offered well above market yields, then you're also being exposed to some sort of risk (whether you know it or not). Bottom line: there is basically only one way to increase yield and that is to increase your risk exposure.