Beware These 5 Problematic High-Yield Investments

When Pat Conway invested the majority of his life's savings a few years ago in two non-traded real estate investments, he thought he had secured his retirement once and for all. Behringer Harvard Short-Term Opportunity Fund and Behringer Harvard REIT I yielded 3% and 7%, respectively. Moreover, his broker vowed that double-digit capital appreciation would surely follow, so Conway reinvested most of his dividends in the ventures. "That was my anchor for retirement," says Conway, 66, a retired computer programmer from Lenexa, Kan., a suburb of Kansas City.

Instead, the housing market turned and the two investments stopped paying dividends. Both investments were initially priced at $10 a share, but Conway has only recently been able to exit Harvard REIT, a real estate investment trust, by selling his stake in a private sale for $2.30 per share. Short-Term Opportunity, a limited partnership, fell to $2 per share before entering liquidation and has frozen all sales and redemptions.

With interest rates at near-record lows, many income seekers are being lured into exotic high-yield instruments without understanding their risks. Below, we profile six such problematic investments. The best way to avoid a horror story is to arm yourself with an arsenal of skepticism if someone tries to sell you an unfamiliar investment. "With the stock market, I may lose money," says Conway, "but at least I know what the rules are."

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Non-traded REITs and limited partnerships. You're probably familiar with traditional real estate investment trusts. Favored by income investors for their hefty yields, most REITs invest in property and distribute nearly all of their earnings to shareholders.

But non-traded REITs have several shortcomings. One problem with the non-traded structure is that investors, such as Conway, who want to bail may have no options to do so at a fair price. Another is that there's no objective way of determining the investment's true value. A non-traded REIT's board of directors generally sets the product's share price and may update the REIT's net asset value per share infrequently. "You can't watch the market every day to figure out if your investment is in trouble," says Jeff Pederson, a lawyer in Denver who works with investors.

Like most products on this list, non-traded REITs are typically sold with a number of upfront charges, including commissions, which can reach as high as 15%. "In order to earn back your principal and achieve the desired return, the investment has to be risky," says D. Daxton White, a lawyer in Chicago who represents investors in disputes. Non-traded REITs may return principal or take on debt to fund payouts if they don't earn enough from operations.

Though one of the non-traded products Conway bought was structured as a REIT and the other, Behringer Harvard Short-Term Opportunity Fund, was structured as a limited partnership, they carry similar risks. A limited partnership is a corporate structure that allows many investors to come together to buy something that they can't afford individually. But as with non-traded REITs, it may be difficult or impossible for investors to sell shares in LPs.

Perilous private placements. Often promoted by promising fat payouts, private placements have risks similar to those of non-traded REITs, except that they may fund just about any sort of business. Tom Ajamie, a lawyer specializing in fraud and coauthor of the book Financial Serial Killers, says he's seen private placements used to fund restaurant chains, a holding company that owned Chinese travel agencies and a firm that planned to develop solar panels for golf carts. Unlike most non-traded REITs, private placements needn't register with the Securities and Exchange Commission or provide periodic financial statements. The loosey-goosey regulatory treatment of private placements also makes it easier for their sponsors to hide fraud than in more closely monitored areas of the financial world. Says White, "This is the Wild West of investing."

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Fancy CDs. It sounds like a no-brainer: Capture stocks' gains if markets rally, and protect your principal if shares fall. Market-linked certificates of deposit are generally insured by the Federal Deposit Insurance Corp. But rather than pay a fixed interest rate, these CDs pay a return that's tied to the performance of stocks — usually a well-known benchmark, such as Standard & Poor's 500-stock index.

But the pitches usually obscure the shortcomings of these products. In some cases, the calculation for the interest they pay is based on complex formulas that decrease an investor's chance of earning anything at all. For example, one CD offered by JPMorgan Chase calculates an investor's return by taking the average level of the Dow Jones industrial average on 11 days over the lifetime of the CD, which matures in 2015. If that average level is higher than the index's level at the product's issue, investors make money. If not, they make nothing. As with most stock-linked CDs, investors collect no interest on the JPMorgan product until it matures, and they have no early-redemption options. JPMorgan pays a commission of 3.75% to sellers of the CD. "These are sort of heads-I-win-tails-you-lose products," says Ed Pekarek, a securities law professor at Pace Law School.

Complex notes. Structured notes look much like stock-linked CDs, but they lack FDIC insurance. Like bonds, these notes are unsecured debt obligations of the banks that issue them. And some notes offer no guarantees to return investors' original principal, in which case you could lose all of your investment. For example, Accelerated Return Notes Linked to the S&P 500, offered by Bank of America, promise to return three times the index's potential gains over a two-year period while limiting losses to no more than the index's potential decline. However, the product caps a buyer's potential gain at 19.25%, or 9.2% on an annualized basis. Meanwhile, an investor could lose all of his or her principal if the market stumbled or if Bank of America defaulted on its obligations.

Risky closed-end funds. With yields as fat as 17%, closed-end funds are almost irresistible. But the spectacular yields, combined with the quirkiness of these funds, suggest that you should approach them carefully.

Closed-end funds can use borrowed money to juice their yields. Because closed-ends issue a set number of shares and then trade like stocks, their share prices can differ widely from the value of their underlying holdings. Ideally, you want to avoid buying a fund that sells at a large premium to its net asset value per share.

But some investors take on excessive risk by buying closed-ends at huge premiums. And to make matters worse, some investors pay premium prices for closed-ends that include return of capital in their payouts. For example, at its April 5 closing price of $22.02, Pimco Global StocksPLUS & Income (symbol PGP) traded at a whopping 56% premium. Yet 7 cents of the fund's 18-cent monthly distribution represents a return of capital.

Funds that pay out more than they earn are candidates for cutting their dividends. "With closed-end funds, if you're chasing the highest yield, you're more likely to experience dividend cuts," says Greg Neer, an analyst at Relative Value Partners, a Northbrook, Ill., investment firm. To check whether a fund is returning principal, look it up at www.cefconnect.com, which breaks down the sources of funds' distributions from income, capital gains and returns of capital.