If You Don't Get It, Don't Buy It

Recently a client of mine called me and asked me about a bond fund that his other broker was telling him about. When I researched the fund, the actual way the fund works, it is almost laughable that this type of security exists. If you went to a store and bought a pair of jeans and the sales person told you that these are the best type of jeans but if (or when) they fall apart we'll give you another pair and if that pair falls apart we'll just give you another one, would you buy the jeans? I say probably not because how is this jean company going to have the money to keep replacing your decayed jeans when you only bought one pair to begin with? This is the same idea when dealing with securities. If you don't understand how an investment is going to pay you, or it doesn't make sense logically, then it's simply not a solid security. When you invest in a security whether it be stocks or bonds, your broker should be able to tell you exactly what will be paying your dividend/interest. If he or she can't explain it in terms that you understand, don't buy it.

This particular fund was supposed to pay out 2.65% and was rated AAA. When I looked at the individual bonds that made up the fund, nearly all of them were no where near AAA quality, in fact, 20% of the fund were bonds that were rated below minimum bank investment grade (Baa3/BBB-). I called the company that put the fund together and asked how this fund had a AAA rating. The woman I spoke to explained to me that the fund starts out with a AAA rating, if it gets downgraded to AA, the payout instead of being 100% of 2.65% it will be 110%. She then told me that if it gets downgraded again to A the fund will pay out 125% and then 150% if it gets downgraded to BBB and then it will pay 200% with a BB rating meaning instead of paying out 2.65% it will pay 5.30%. I asked how this was possible because if the fund gets downgraded, it probably means that one of the bonds within it went bad, and therefore is not paying so where are they going to get the money to pay the holders the extra yield promised? It simply doesn't make sense. As an example, if there are 10 bonds that make up a fund and they each pay $10 so the investor is making $100 off the fund and one of these bonds goes bad and the fund is only collecting $90, how is it going to pay the investors $110? Where is the money supposed to come from?

This is exactly what got the securites industry in a mess to begin with, people were buying these Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs) without a clue as to what was paying their interest. Even the brokers didn't know exactly what they were selling! The broker that presented this fund probably only knows that it's a bond fund and rated AAA, that's it. Everyone thinks finance is an area that's very confusing but that's only true when your broker doesn't understand the security they're presenting and therefore can't explain it to you.

The moral of the story is if you don't understand how a company is going to continue to give you new jeans to wear when the ones have keep falling apart and you only bought one pair, then what's probably going to happen is the company will go out of business and you will be left pants-less.