When the markets are down, high yield funds (closed-end “junk” bonds) suffer more than other investment instruments. This is precisely what is happening today.
High yield closed-end funds (CEFs), sometimes referred to as “junk bond funds,” usually trade on stock exchanges, and so supply and demand typically drive their prices. As we experience decreasing confidence and growing instability in the markets, CEF junk bond net asset values (NAVs) are taking a serious hit.
The market, as a whole, has suffered a decline, thanks to coronavirus shutdowns hurting businesses, newly unemployed workers’ facing financial strains, and an ongoing oil price war creating further economic instability by collapsing oil prices. But CEF junk bonds have taken the lion’s share of the damage.
Understanding High Yield (“Junk”) Bonds
Because CEF junk bonds are leveraged (meaning the fund uses additional borrowed money to invest beyond the investor’s capital) and are often illiquid (meaning they may rarely trade, they have been falling faster than other investments. In March, some CEF high-yield bond funds sustained a drop nearly double that experienced by the broader high-yield market. Investors are becoming increasingly concerned about risk, and they can’t seem to shake themselves free of their CEF junk bond funds fast enough.
When a panic in the market causes a mass run on these funds, it becomes even harder to find people willing to buy them, resulting in their trading at the wrong prices.
How a Pandemic-Torn Market Affects Junk Bonds
Throughout any period of market volatility, economic fluctuations, high unemployment, recession, or otherwise struggling/failing economics, CEF junk bond yields can plummet. To be clear about where the U.S. stands in this picture, The Washington Post reported that the number of unemployment claims made in the first week of April reached 6.6 million—these were all new applicants. The previous week’s number was 6.9 million, preceded by 3.3 million unemployment claims before that. The current tally of 26.5 million citizens filing unemployment claims—in just a few weeks—surpasses the number of unemployed during the Great Depression—many times over.
Investors should also consider the number of businesses that have been forced to shutter due to the coronavirus pandemic. Forty-six states shut down nonessential businesses in an effort to slow the virus’ spread.
To add to the mix, we have been suffering the collateral damage of an ongoing oil price war between Russia and Saudi Arabia. The fight has driven the oil industry into a particularly dark and struggling place, with a huge economic impact on the U.S.
It’s easy to comprehend why so many investors are panicking.
Financial Advisors and Brokers Should Have Investors’ Backs
Although CEF junk bonds can rebound when market confidence returns and NAVs stabilize, nobody can predict when these factors will come into play. “In the meantime, watch the stampede out of bonds. Be the first mover and not the last,” cautions a Yield Hunting Alternative Income Investments analyst in an article written for Seeking Alpha.
Brokerage firms and financial advisors are aware of the high risks associated with CEF junk bonds. For many people, this type of investment works with their financial health, goals, and strategic willingness to take on the risk of a junk bond in exchange for the potentially high yield it could generate.
However, financial advisors carry a legal obligation and ethical duty to match their clients with investments that square with not only their financial goals but also their ability to assume risk. The Financial Industry Regulatory Authority (FINRA) outlines suitability rules (FINRA Rule 2090) to which brokers must refer and adhere before they recommend investments to their clients. In order to satisfy FINRA’s definition of a suitable investment, the financial advisor or broker must consider their client’s:
- Other investments
- Financial needs and situation (annual income, liquid net worth)
- Tax status
- Investment objectives
- Investment experience
- Time expectations for reaching their investment goals
- Need to convert investments to cash without suffering a loss (liquidity)
- Risk tolerance (willingness and ability to lose their investment in exchange for higher potential returns)
When financial advisors and brokers deviate from this checklist and recommend unsuitable investments, they put their clients at risk for suffering substantial losses.
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