Bonds and preferred stock are frequently touted by stockbrokers and investment advisors as suitable investments for customers who need income or want to preserve their capital. When recommending bonds or preferred stocks, stockbrokers and investment advisors have a fiduciary duty to only recommend investments that are suitable based on their customer’s financial situation and needs.
Bonds & Bond Funds
Bonds and bond funds are often used as investment vehicles to offset risk; however not all bonds are completely risk free. Even a bond portfolio that holds high quality bonds can be overly risky if the bonds purchased are concentrated in a single company, industry or sector. Many investors have been enticed by brokers offering bonds with attractive returns not realizing that they were purchasing riskier high-yield bonds or “junk bonds.” Purchasing a bond mutual fund can be more confusing because the fund can hold a combination of investment grade bonds and high-yield bonds. Some bond funds employ aggressive trading schemes in an effort to extract even higher yields. Stockbrokers and investment advisors have a duty to provide their customers with all the necessary facts and information about the bond or bond fund they are recommending so that the customer can make an informed investment decision.
The price of bonds will fluctuate depending upon market conditions, interest rates and the default risk of the issuing company. Although a bond’s principal is repaid when the bond matures, some long-term bonds have maturities greater than 10 years. For this reason, having a bond portfolio that only holds bonds with long maturity dates may be unsuitable, particularly for older investors who have a shorter investment time horizon. Also, in the case of tax-free municipal bonds, the tax advantage diminishes when the customer’s federal income tax bracket is 28 percent or less.
A common mistake made by investors is the misconception that investing in preferred stocks is always a conservative investment strategy. In reality, preferred stock is only marginally safer than common stock issued by the same company. Purchasing preferred stock in a company with a high default risk is anything but a conservative investment. Even if the company has a low risk of default, investing the bulk of one’s portfolio entirely in the preferred stock of a single company or related companies carries with it the risk of overconcentration.