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Energy Related Bonds & Structured Notes – A Potential Wolf in Sheep’s Clothing?

As noted in a February 5, 2016 article in The Wall Street Journal (“The Oil Rout’s Surprise Victims”), the epic collapse in the price of oil, from more than $100 per barrel less than two years ago to below $30 last week, has “crushed investors in the futures market, energy partnerships, high-yield corporate bonds and the shares of oil and gas companies.”

But there is another sector of the energy market – short term bonds and structured notes issued by major investment firms whose returns are linked to the price of oil or other energy-related assets – that could also be decimated in the coming months unless there is a significant recovery in oil prices.

These securities, which have been sold to wealthy families and individual investors who want to limit the risk or amplify the return of more-conventional investments, often carry such alluring nicknames as “Phoenix,” “Plus,” “Enhanced Return” or “Accelerated Return.” They typically mature in two years or less and pay commissions of about 2% to the brokerages that sell them which has included units of Bank of America, Citigroup, Credit Suisse, Goldman Sachs, J.P. Morgan Chase, Morgan Stanley and UBS.

Unfortunately, they use intricate combinations of options contracts to skew the payoffs from changes in energy prices: investors can make a lot of money if oil goes up a little, and they can lose much or all of their money if it goes down a lot. At current prices, most of these securities are underwater and there will have to be a significant increase in the price of oil (estimated at 50% to 100%) for them to return to their original value.

As noted by Craig McCann, principal at Securities Litigation and Consulting Group, a research firm in Fairfax, Virginia and one of the leading experts in the securities field, “this is not really an investment strategy so much as a wager on which way oil prices are going” and “some of the risks and costs of that wager are masked by the complexity of it.”

Furthermore, there isn’t any secondary trading in most of these securities, meaning that the issuing bank may often be the only buyer which, more often than not, does not benefit the investors who own them.

If you are an individual or institutional investor who has any concerns about your investment in any energy related bonds or structured notes, please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).

Breaking Bad, the Junk Bond Edition

Junk bonds, better known as high-yeild debt have seen much better days and strategists say that investors may be focusing too much on the role energy has played in the decline while underestimating other risks.

According to Matthew Mish, global credit strategist at UBS “Energy, bond valuations are pricing in an uplift in underlying commodities, so there’s more downside risk if prices hold at these levels for a long time or go lower,” And elsewhere, he added, “we do not see a marginal buyer for lower-quality credit.”

David Kotok, chairman and chief executive of Cumberland Advisors, worries more about the currency risk. “Foreign currencies — even those in developed markets such as Canada — have been crushed under a strong United States dollar. Over the past year, the Canadian loonie has fallen 17 percent against the American currency; the Brazilian real has plummeted 34 percent”, says Kotok.

Joseph F. Kalish, chief global macro strategist at Ned Davis Research concern is for the market damage seems to be spreading beyond commodities. Kalish says, “That’s what has gotten me more concerned this time around, compared to the generalized, risk-off sell-off we had in the middle of last year,”.

SEC Releases Examination Priorities for 2016

Released by the Office of Compliance Inspections and Examinations of the Securities and Exchange Commission, Examination Priorities for 2016.

Goldman Sachs to Pay $5B To End MBS Probes

CEO Lloyd Blankfien of Goldman Sachs plans on paying $5.06B to end federal and state investigations of its underwriting and sale of mortgage-backed securities from 2005 to 2007. The investment banking giant will pay $2.3B in civil penalties, $875M in cash payments, and $1.8B in consumer relief to settle all claims. The payout will lop off $1.5B from Goldman Sachs’ after-tax earnings, according to Law 360.

2016 FINRA Regulatory and Examination Priorities Letter Released

Each year, FINRA publishes its Annual Regulatory and Examination Priorities Letter to highlight issues of importance to FINRA’s regulatory programs, Regulatory and Examination Priorities Letter.

Many of the concerns in last year’s letter remain priority again for 2016. With the recent increase in interest rates, FINRA reiterates the worries mentioned in last year’s letter regarding interest rate-sensitive products. Firms are urged to evaluate their product offerings to determine where heightened concerns about interest rate sensitivity are relevant.

FINRA Chairman & CEO Richard Ketchum says, “Firm culture, ethics and conflicts of interest also remain a top priority for FINRA. A firm’s culture contributes to, and is also a product of, a firm’s supervision and its approaches to identifying and managing conflicts of interest and the ethical treatment of customers. Given the significant role culture plays in how a firm conducts its business, this year the letter addresses how we will formalize our assessment of firm culture to better understand how culture affects a firm’s compliance and risk management practices.”

Liquid Alternative Funds – Market Volatility Exposes Hidden Risks

As noted in a December 31, 2015 article in The Wall Street Journal (“The Year the Hedge-Fund Model Stalled on Main Street”), more “liquid alternative” mutual funds closed in 2015 than in any year on record, according to research firm Morningstar Inc., due, in significant part, to increased market volatility.

In all, according to Morningstar, 31 liquid-alternative funds closed in 2015, up from 22 a year earlier, as inflows dwindled and performance weakened.

The results show that enthusiasm is fading for what had emerged in recent years as one of the hottest products in asset management – funds that combine hedge-fund strategies like shorting stock with the daily liquidity of mutual funds.

Assets in liquid-alternative funds grew to $310.33 billion at the end of 2014 from $124.44 billion at the end of 2010. But the inflows have slowed as performance faltered in 2015 – in fact, it is estimated, according to the WSJ article, that just $85.1 million flowed into liquid-alternative funds in 2015.

The host of funds liquidated this past year included strategies run by J.P. Morgan Asset Management, Guggenheim Partners LLC and Whitebox Advisors LLC. The closed funds were a range of unconstrained bond funds; managed future funds, which bet on futures contracts in a number of markets; and equity funds that bet on stocks rising and falling – are of which tend to have highly concentrated bets that expose investors to riskier assets than typical mutual funds do.

If you are an individual or institutional investor who has any concerns about your investment in any liquid alternative fund, please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).

Prospect Capital Corporation – a Major Player in the Business Development Company (BDC) Marketplace – Faces Increased Scrutiny and Questions

As noted in a December 24, 2015 article in The New York Times (“Obscure Corner of Wall St. Draws Skepticism from Investors”), one obscure sector of the stock market – Business Development Companies (“BDCs”) – has been the subject of increasing controversy over some of its results and fees.

BDCs are firms that were created by Congress in 1980 to encourage investment in small businesses whose growth may generate jobs. They sell stock to the public and then use some of the proceeds to make loans to emerging businesses for a variety of needs. The category has grown tenfold over the last decade, to $64 billion in assets. That is partly because business development companies offer higher yields in exchange for the high-risk nature of their assets, and partly because they cater to a market that big banks have retreated from since the financial crisis.

One of the most criticized business development companies, however, is Prospect Capital Corporation (NASDAQ: PSEC). With $6.6 billion in assets as of September 30, 2015, Prospect is a large player in the category. But in the last year and a half, its stock price and net-asset value per share have been steadily sinking. Even before the recent junk-bond market upheaval, Prospect has traded at a discount to net-asset-value of more than 30 percent this year, well below the average of less than 20 percent for such firms.

Some analysts have accused Prospect of charging what they say are conspicuously high fees, even as investor returns have faltered. And others have taken issue with the compensation paid its chief executive, John F. Barry III — more than $100 million annually in recent years, according to estimates by former employees and an outside analyst.

Prospect invests in high-yield, high-risk assets like stocks, loans and bonds of companies through private equity buyouts, finance companies, debt pools like collateralized loan obligations, real estate investment trusts, aircraft leasing and even online loans – a significant portion of which are leveraged. Prospect’s fees, however, like those of many business development companies, are similar to those of private equity funds. Its external manager charges a 2 percent annual management fee on all assets plus an incentive fee of 20 percent of certain income gains — and administrative expenses — at the high end of the sector. For its fiscal year that ended in June, the Barry-owned manager received fees and expenses totaling $240 million, or about 3.5 percent of its total assets, according to the company’s annual report.

Some analysts say Prospect has often paid out dividends above its earnings, and sold stock below its book value, both of which can hurt investors. Both moves have helped Prospect raise its assets tenfold since 2008, also increasing fees. With its shares down 34 percent in the last 17 months, Prospect has curtailed new stock sales. As a result, growth of its assets slowed to 5 percent in its latest fiscal year from an annual rate of 58 percent over the previous five years.

One reason for Prospect’s big discount to net-asset value, now 28 percent, is that some investors are skeptical of the value Prospect reports for some assets – commonly referred to as “Level 3” assets – which means that, rather than being priced based on actual trade prices, these investments are valued by management based on their own estimates and valuation models.

The combination of leverage, questionable Level 3 valuations and excessive fees are, more often than not, an indication of potential significant concern – especially in a rising interest rate environment.

If you are an individual or institutional investor who has any concerns about your investment in Prospect Capital Corporation or any other Business Development Company (“BDC”), please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).

Tom Buck Update

The latest on broker Tom Buck, is a settlement has been made costing $4.1 Million for Merrill Lynch. For the all the details visit http://www.ibj.com/articles/56290-buck-settlements-cost-merrill-lynch-41m?utm_source=this-week-in-ibj&utm_medium=newsletter&utm_campaign=2015-12-19

ArbitrationTask Force Attorney Mark Maddox Served on Final Report Issued

Our own attorney Mark Maddox served as one of the 13 members of the FINRA Dispute Resolution Task Force Members. FINRA released their recommendations this week in the  Final-DR-task-force-report. With 51 recommendations to enhance the arbitration and mediation forum, the next step is for FINRA’s Standing Board Advisory Committee to review them. The National Arbitration and Mediation Committee (NAMC) will meet to discuss the report and can make recommendations on items to implement immediately, items that will require further discussion and items that may not be feasible. Click here for a link to FINRA’s press release on Explained Decisions, Increased Arbitrator Honoraria, Creation of a Special Arbitrator Panel for Expungement Hearings Among Recommendations

High-Yield Bond Funds: A Growing Crisis of Concern

As reported by The Wall Street Journal on December 15, 2015 (“Investors Abandon Risky Funds”), the U.S. High-Yield bond rout has deepened this week, with the bonds of dozens of low-rated companies falling anew and the shares of some large fund-management firms tumbling as well.

Investors retreated from the U.S. junk-bond market for the third straight trading day and stocks of large asset managers were hit by heavy selling, a sign that the deepest turmoil in financial markets since summer is intensifying. Some investors reported difficulties selling lower-rated bonds quickly or at listed prices, though others said the market appeared to stabilize somewhat after the record plunge in prices on Friday.

While the market for the highest-quality bonds remains intact, there are signs across Wall Street that investors are losing confidence in lower-quality bonds and the firms that most actively deal in them.

Waddell & Reed Financial Inc., which manages the $6.2 billion Ivy High Income Fund, has suffered the largest outflows this year of any junk-bond fund. According to Morningstar, investors withdrew $1.8 billion from the fund this year through November, the highest level of any high-yield bond fund during that period. The Ivy High Income Fund is among the worst high-yield performers this year, according to Morningstar. The fund is down 6.4% this year through last Friday.

AllianceBernstein Holding LP, which runs the $5.8 billion AB High Income Advisor fund, dropped 7% and Affiliated Managers Group Inc., a major investor in Third Avenue Management LLC, which last week suspended withdrawals at its junk-bond fund, dropped 5.7%.

If you are an individual or institutional investor who has any concerns about your investment in high-yield bond funds, please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).


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