John is a relatively conservative investor. He has recently come into a large inheritance and wishes to invest the money where he can get a good return, but not worry about losing his principal. His broker recommends that he buy 20-year corporate bonds in the country’s largest automobile company, United General. His broker assures him that the bonds are secured by the assets of the company and the interest payments are contractually set. He explains that although all investments carry some risk, the risk of losing his investment with these bonds is minimal. John buys the bonds and over the next two years enjoys the steady stream of interest payments. During the third year, United General posts the largest quarterly loss in its history. Although the company is far from bankruptcy, the bond rating agencies downgrade the company’s bonds to junk status. John is horrified to see the decline in the price of his bonds as he is considering selling a large portion of them to buy a home. When he discusses his dissatisfaction with his broker, his broker tells him that he is still receiving his interest payments and if he holds the bonds until maturity he will not sustain a loss. The broker reiterates that in their initial meeting John’s concerns were safety of principal and interest payments and the investment still offers both of these.
a. Was the broker being ethical by not informing John of the other risks involved in the purchase of bonds? Why or why not?
b. What could John have done differently with his bond investments if he anticipated buying a home in the next three to five years?