Junk bonds are frequently advertised as “an attractive alternative to term deposits”. But junk bonds do not guarantee you a return, and they are very high risk. They often claim to have a 5% return – which is ludicrous in itself when you think about standard interest rates. And sometimes, carefully selected terminology confuses people into thinking junk bonds are actually like term deposits offered by banks. They’re not.
Companies are not offering this 5% return to be nice to you. They do it because they are taking on an extremely high risk. So, if you choose to invest in them, you’re taking on an incredibly high risk for the chance of a high return. Junk bonds, sometimes referred to as high-yield bonds, have a high default risk.
If the business goes into liquidation, instead of getting that 5% return, you’ll probably end up with no return at all, and most likely lose your initial investment, too.
Everyday Australians fall for these schemes often, with the latest example being that of Mayfair 101. And while ASIC security is usually on top of this issue, unfortunately it’s often too late –people have already invested (and consequently lost) their hard-earned money. Legislation around this, as well as court orders, take time.
There’s a phrase that we’ve heard companies use to persuade people to invest. They say your investment will get equity-like returns but without volatility. If you hear this, run the other way. You cannot have returns higher than interest rates without significant risks – that’s a fact.
So how do we avoid falling into this trap?
Our first conclusion is to do ‘the smell test’ – or as we at Money Over 50 like to call it, ‘Hogue’s law’. And that is: if it seems too good to be true, it always is. Term deposits are usually around 1%. These junk bonds are 5%. How is that possible? It’s not. Someone somewhere is paying for that. Those companies have to offer 5% to get investors because nobody would invest otherwise. And, as we always say to our clients, if you invest in just one company, you need to be prepared to lose it all. The same thing goes for this scenario.
Our second conclusion is to see cash for what it is. There is a risk in having all your money in cash (i.e., not invested in the sharemarket or going into your super) but people do this in order to be able to access it easily. Money in the bank should earn 0.5 – 1% interest roughly. The ability to withdraw quickly when markets are down or in case of emergency is why people choose to have cash in the bank rather than invested. It provides a level of security, but again, the trade-off is the small return.
If it sounds too good to be true, and you’d like a second opinion, contact us.
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Dallas Davison, Michael Hogue and Ali Hogue.