The Securities Litigation Expert Blog

Sustainable Withdrawal Rates - Revisited

Posted by Jack Duval

Nov 11, 2013 4:02:16 AM

William Bengen, the financial advisor who created one of the most heavily cited studies on sustainable withdrawal rates, is backing off his previous findings.  (Barron's)  Bengen's 1994 study (Journal of Financial Planning) concluded that a portfolio balanced 50/50 (stocks/bonds) could sustain a four percent withdrawal rate though almost all market scenarios.  (Importantly, Bengen's analysis assumed the four percent was set off of the initial premium amount and then was adjusted each year for inflation.)

Bengen's hedging should be obvious to anyone in the financial planning business.  Yields on stocks have fallen and yields on bonds have plummeted, making it very difficult to create the required returns without capital appreciation.  This simple fact requires advisors and investors to make a difficult decision:  settle for lower withdrawal rates, or take more risk.

From the big moves in junk bonds, master limited partnerships, and other high-risk investments, it appears that many advisors and their clients have opted to take more risk.

As many have warned, this has usually ended badly.  See here, here, and here for our previous discussion of yield chasing.

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Topics: yield chasing, sustainable withdrawal rates, investments, risk, fixed income

New Financial Assets Increase Market Risks

Posted by Jack Duval

Apr 23, 2013 4:49:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

A new paper from Alp Simsek of MIT makes an argument that financial innovation always increases market risks.  (See the WSJ article on the paper here, and the paper here.)  Essentially, the argument boils down to this:


    1. New financial products create new disagreements about valuations and outcomes;

    1. These products are new and therefore disagreements are bound to be wide;

    1. New products amplify speculation on existing disagreements;

    1. They also allow traders to purify their bets (and speculate on more narrow outcomes) or in economic terms, the traders opportunity set has increased;

    1. When traders are able to make purer bets, they make larger bets


The traditional argument for financial innovation is that it allows for risk sharing, and that those who don't want to take certain risks can trade them to others who want them.  This paper is interesting because it shows that aggregate risks are increased by the endogenous introduction of new financial products (by amplifying old disagreements and introducing new disagreements).
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Topics: investments, CDS, Structured Products, financial innovation, RMBS, CDO, risk, Complexity

Risks of Structured Products

Posted by Jack Duval

Mar 22, 2013 2:53:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

While structured products are often marketed with one-page fact sheets, they are usually highly complex.  Some of this complexity can be seen in the multitude of risks that can be found in most structured products.  Some of these risks include:


    • Credit (Issuer)

    • Reference Security

    • Liquidity

    • Maturity

    • Interest Rate

    • Leverage/Embedded Option

    • Concentration


Evaluating these risks is beyond most investors and many securities sales personnel, leading to portfolios which can be much more risky then either intended.

Compliance and supervisory staff should be extra vigilant of portfolios with high concentrations of structured products.  Portfolio risk assessment by supervisory staff and subsequent frank discussions with registered representatives and clients is a must to avoid excessive and unknown risk-taking.

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Topics: FINRA, Investment Advisors, investments, supervision, Structured Products, risk, Complex Investments, Compliance, Complexity

Finra Issues Investor Alert on Duration Risk

Posted by Jack Duval

Feb 15, 2013 4:26:47 AM

Finra has issued an Investor Alert explaining duration risk.  (Finra)  For those of you unfamiliar with duration, here's what you need to know from the Investor Alert:

The higher a bond’s duration, the greater its sensitivity to interest rates changes. This means fluctuations in price, whether positive or negative, will be more pronounced. If you hold a bond to maturity, you can expect to receive the par (or face) value of the bond when your principal is repaid, unless the company goes bankrupt or otherwise fails to pay. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. For instance, if interest rates were to rise by two percent from today’s low levels, a medium investment grade corporate bond (BBB, Baa rated or similar) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. A similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a loss in value of 26 percent.1 The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes. (Emphasis added)

There is no doubt that from current levels, a rise in interest rates has the potential to cause widespread losses, especially in lower-quality issues.  Hat tip to Finra for trying to get ahead of it with their investor education efforts.  Compliance and supervisory personal should take note as well.

See our previous coverage of interest rate risk here, here, and here.

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Topics: FINRA, duration, investments, risk, fixed income, Compliance, education

Finra Focus on High Risk Municipal Bonds

Posted by Jack Duval

Feb 6, 2013 3:36:00 AM

The Bond Buyer has an article out on high risk municipal bonds and Finra's focus on them.  (BB)  Anyone who has been around the muni market knows there are risks, especially with exotic revenue bonds.  Some types of issues that gave concern included:


  • Private Community-Development District Bonds - 16.56% default rate

  • Nursing Home Bonds - 3.97% default rate

  • Assisted-Living Facility Bonds - 4.48% default rate


Finra cited a study by Richard Doty, which can be found here.


Our previous coverage of Finra focus areas can be found here.
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Topics: FINRA, Bond Buyer, default, investments, municipal bonds, Richard Doty, risk, fixed income, Compliance, regulation.

Predictive Analytics for Banking Conference

Posted by Jack Duval

Dec 6, 2012 8:45:22 AM

I'm a little late on this, but IE is sponsoring a predictive analytics conference for the banking industry, it runs two days and starts today.  (IE)  Many heavy hitters from the big banks.  I can't go, but it looks very interesting.

You can also get their on-demand content here.

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Topics: IE, Statistics, Data Analysis, finance, banking, risk, Compliance, Predictive Analytics, education

The Bubble in Yield Plays Continues to Grow

Posted by Jack Duval

Oct 29, 2012 3:33:29 AM

Nathaniel Popper, reporting in the New York Times, has a good piece on how individual investors are plowing into junk bonds just as they are getting more risky.  (NYT)  This continues the trend of yield chasing we have documented with our coverage of Energy plays in Master Limited Partnerships here.

The scenario is simple, the Fed has cut interest rates to near zero and intends to keep them there for the foreseeable future, while at the same time the baby boom generation is retiring at an accelerating pace.  These retirees need income but don't want the risk of equities.  Unfortunately, they are running right into the teeth of the bubble forming in risky income plays.  Like all bubbles, it will end badly.

Here are some highlights from the article:


  • Junk bond issuance has reached record levels this year

  • The average credit rating of companies issuing junk bonds has declined

  • The proceeds of many of these offerings are not going to operations, but to cash out private equity funds

  • Retail investors added $2.1 billion in the first three weeks of October, while institutional investors sold $256 million over the same time period

  • Retail investors added $22 billion to junk bond funds this year compared to $8.3 billion in all of 2011

  • LBOs are back in vogue

  • More and more junk bonds are issued that allow the borrowers to skip interest payments


For those of you who have been around for a while, this all sounds like the years leading up to the collapse of the junk bond market in the early 1990's.  (PIK bonds anyone?)

Key takeaways for investors and industry participants:


  • Investors should beware of the increasing risk in these yield plays, both from an investment cycle and individual investment perspective;

  • Compliance/supervisory officers should beware of seemingly high allocations to fixed income that are actually invested in speculative or aggressive high yield bonds or other risky income investments; and make sure the accounts are coded for such investments and that the advisor and investor are both fully aware of the risks


 
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Topics: chasing yield, Master Limited Partnerships, junk bonds, MLP, investments, LBO, Nathaniel Popper, risk, Compliance, private equity, NYT

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