Not so long ago, when investors heard the word “bond,” they thought safety.
Fixed-income and bond strategies were considered nice conservative investments, but that was before Wall Street introduced an array of confusing products and securities that drew highly speculative, illiquid assets into a market that is normally a haven for risk-averse investors.
Ultra-short bond funds are not suitable for every investor, and some investors have experienced large losses due to the fraudulent sale of these funds. Brokers, investment advisors and their brokerage firms violate their fiduciary duties to customers when they recommend or sell investments that are not suitable for their clients’ goals and risk profile, and they can be held liable.
Any one of these ultra-short bond funds may be deceptively speculative. As the name suggests, an ultra-short bond fund invests only in fixed-income instruments with very short-term maturities. These are typically instruments with maturities of around one year.
Ultra-short bond funds tend to offer higher yields than typical fixed-income instruments like money markets, and they usually experience less price fluctuation than a typical short-term fund.
Investors would be wise to approach these investments with caution, however. The Financial Industry Regulatory Authority (FINRA) states in a regulatory notice that some investors fail to appreciate the difference between ultra-short bond funds and money market mutual funds.
Both of these products are mutual funds that generally invest in fixed-income securities with short maturities and have been described as “cash-enhanced” or “cash equivalents” in some cases.
The similarities end there. Unlike ultra-short funds, money market funds operate under a set of strict rules, according to FINRA. Money market funds may only invest in high-quality, short-term investments issued by the U.S. government, state and local governments and U.S. corporations. Money market funds are also are subject to strict diversification and maturity standards.
Ultra-short bond funds are not subject to these requirements. Their goal is usually to produce higher yields by investing in securities with higher risks.
While a money market fund seeks to maintain a stable net asset value of $1 per share, the net asset value of an ultra-short bond fund is likely to fluctuate, FINRA says.
Unscrupulous or careless stockbrokers have marketed ultra-short bond funds as conservative when they are nothing of the kind. Sometimes brokers and their firms have relied on confusing language, such as calling these investments “cash equivalents.”
Much can go wrong with an ultra-short bond fund. During the credit crisis that began in 2008, some of these funds experienced dramatic increases in redemptions and declines in their share price. While part of the blames falls on ratings agencies that gave the highest AAA rating to bonds tied to toxic sub-prime mortgages, the blame also lies with brokers and firms who sold these unsuitable products to investors who did not understand the risk.
As example of an ultra-short bond fund gone bad, witness what happened regarding YieldPlus, an ultra-short bond fund managed by Charles Schwab Investment Management, an affiliate of Charles Schwab & Company Inc.
In Jan. 2011, FINRA announced today that it had ordered Schwab to pay $18 million into a “Fair Fund” established by the Securities and Exchange Commission (SEC) to repay investors in YieldPlus. About $17.5 million of the payment was disgorgement of fees that Schwab had collected for sales of the fund. Schwab was also fined $500,000.
According to FINRA, Schwab failed to change its marketing of YieldPlus even after changes in the portfolio caused it to be adversely affected by the implosion of the mortgage-backed securities market. The drastic change in the fund’s holdings increased risk and price volatility, but Schwab brokers omitted or provided incomplete or inaccurate information in both written materials and in conversations with customers relating to the fund’s risk, as well as its diversification. They continued to sell YieldPlus as a low-risk alternative to money market funds and other cash-equivalent investments.
Schwab sold over $13.75 billion in shares of YieldPlus to customers between September 2006 and February 2008. Schwab solicited sales of YieldPlus totaling about $3.36 billion. About 40 percent of these solicited sales were to investors who were 65 or older.
The origin of the problem was a change made in August 2006. The YieldPlus fund manager submitted a proposal to cease classifying non-agency mortgage-backed securities as an “industry” for purposes of the fund’s concentration policies, and this change was approved by Schwab Investment's Board of Trustees. The fund manager then increased the amount of non-agency mortgage-backed securities in the portfolio to greater than 25 percent of the fund’s assets.
As a result, by February 2008, YieldPlus held over 50 percent of its assets in mortgage-backed securities, and about 40 percent in non-agency mortgage-backed securities.
As the financial markets grew unstable, FINRA found that Schwab either knew or should have known about the dire prospects for YieldPlus. When its net asset value declined in late 2007, there is evidence that Schwab knew YieldPlus was a higher-risk investment than it had been. In fact, Schwab employees began to call the fund “Yield Minus.”
Nonetheless, Schwab continued to market YieldPlus as low risk, claiming it would have few fluctuations in share price. Schwab also knew that YieldPlus was being marketed improperly, according to FINRA. The product manager said the firm needed to stop marketing YieldPlus as equivalent to a money market fund, but the firm never followed up, and the practice never stopped.
YieldPlus began to decline in the summer of 2007 due to its high concentration in mortgage-backed securities. The fund’s net asset value took a plunge. According to FINRA, the fund fell from a high of $9.69 on Feb. 26, 2007, to $8.79 on Feb. 29, 2008, a decline of 9.3 percent.
If you have been sold unsuitable securities, or have been the victim of securities fraud, you should consult with an attorney. The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Firm, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.