Risk, Due Diligence and Higher-Yield Alternatives

With 10-year Treasurys yielding just 2.13%—near their lowest level since September 2017—and CDs and savings accounts mostly offering ultra-low rates, interest in higher-yielding bond alternatives is rising.^[i] Financial news and advertisements frequently feature such options, likely tempting many investors eager to spruce up their fixed income holdings with securities that aren’t struggling to outpace inflation. We sympathize—but also urge caution. As with any investment, it pays to know what you are buying—how it functions and what risks it carries—and resist the “low-risk, high-returning” siren song. As investors in the three examples we explore here show, the alternative could be painful.

First up: Municipal (or “muni”) bonds, which are debt issued by state, county or local governments. These have enjoyed a recent run of popularity: In 2019 through May, investors added $37 billion to muni bond funds—$8 billion of which went to high-yielding muni debt, dwarfing last January – May’s $1.5 billion.^[ii] In our view, munis are overall a-ok as fixed income investments, especially in taxable accounts. They typically offer attractive yields relative to Treasurys and get preferential tax treatment. Moreover, muni defaults are rare. Per Moody’s, the average annual default rate between 1970 and 2016 on five-year muni bonds was just 0.07%.^[iii] Even in the event of default, bondholders typically get some money back. The same Moody’s report noted the average recovery rate on defaulted munis is 66%.^[iv]

However, some recent court cases highlight a muni risk investors may not have considered. Contrary to the common belief cities are legally obligated to service debt as long as they have the funds to do so—and if they don’t, courts will force partial payment—honoring claims can be a political decision as much as a fiscal one. An excellent Bloomberg article documented Platte County, Missouri’s recent decision to stop setting aside sales tax revenues for interest payments on bonds backing a struggling retail development. The county wasn’t out of money and didn’t declare bankruptcy. They just determined the pros of default outweighed the cons. A district judge ruled on June 3 there was “no promise or requirement” for Platte County to make payments—the bond’s contractual obligations were rather flimsy.^[v]

This in itself isn’t new—municipalities have long put get-out-of-jail clauses in bond contracts. But they typically also include clauses noting it is their “moral obligation” to pay and they will do their darnedest to do so. Thing is, “moral obligations” aren’t legally enforceable. If politicians want to invite junk credit ratings and a chilly response from investors the next time they issue debt, that is their (and voters’) prerogative. We see two lessons here for investors: Bond repayment terms may not be ironclad—so understand them before buying.^[vi] Second, this underscores the importance diversifying among issuers, rather than loading up on a single municipality.

Things get dicier when you veer further off the beaten fixed income path. Take peer-to-peer (P2P) loans: Typically unsecured (i.e., collateral-free) bonds created and sold to investors by nonbanks—i.e., lenders that directly connect borrowers and lenders rather than taking deposits and making loans themselves. By targeting borrowers traditional banks overlook and stripping away many of the trappings (and costs) of traditional deposit banking, P2P lenders aim to deliver yields well above CDs and savings accounts without taking on excessive risk.

From a macroeconomic viewpoint, P2P lending is an exciting innovation and can help would-be entrepreneurs get funding. But for investors, there are risks. For starters, borrowers are frequently less creditworthy, likely turning to P2P outfits because traditional banks’ lending requirements are too stringent. Hence, default rates and delinquencies on P2P loans tend to be higher. P2P loans also don’t trade on a secondary market, reducing liquidity. The P2P firm may buy them back and/or facilitate a sale to another lender on its platform, but typically only for a (steep) fee.

Lastly, since P2P loans don’t have the backstop of government deposit insurance, investors may be left high and dry should either the P2P platform or underlying investment implode. Lendy, a UK P2P outfit, is a cautionary tale. It collapsed last month, potentially leaving about 20,000 investors on the hook for around $210 million in (unsecured and uninsured) loans.^[vii]

Our last featured high-yield alternative hails from the UK: Mini-bonds. These are unlisted (not traded on an exchange) British bonds typically issued by small businesses—also usually marketed to individual investors seeking higher yields. We see several reasons for caution. First, mini-bonds are lightly regulated. Since issuers aren’t subject to standard reporting requirements, financial data on them are often scant. They also typically aren’t protected by the Financial Services Compensation Scheme, the UK’s deposit insurance and investor protection program. In cases of default—like mini-bond firm Harewood’s earlier this month—or malfeasance, investors likely struggle to get their money back.

Unfortunately, misconduct and mismanagement are common in the mini-bond space. Sellers often market them as fixed return or as Individual Savings Accounts (ISAs)—tax-advantaged savings accounts in the UK. But they are neither. Such misbehavior often ends badly. Take London Capital & Finance, which bit the dust in January. Investigators later uncovered evidence executives had commandeered invested funds for their own use.^[viii]

If you want to avoid low-yielding government debt, we get it. But we think investors are best served sticking with more traditional offerings like run-of-the-mill corporate bonds. If you find yourself checking out fringe interest-bearing investments, consider whether you are chasing capital preservation and growth, which can’t coexist. Second, listen to markets’ signals. Yields far higher than broad-market averages indicate—and compensate for—high risk. To guard against unpleasant surprises, start by reading the fine print, weighing the risks and questioning promises that seem too good to be true.