One of the most conservative investment options around is what are known as capital-guaranteed products. This type of product allows investors to invest in certain assets (e.g. stock market indexes) while not putting their capital at risk. Unlike investing directly in shares, where you might lose money due to falling prices, in these products the idea is to protect the investor’s capital from the risk of volatility (price movements) and “simply” putting the potential return at risk.
But how is the capital guaranteed? Is it done by magic?
What we would like to share with you today is that a ‘‘Capital-Guaranteed’’ product is certainly designed to protect the investor; however, there are other factors you need to keep in mind.
Here’s an example to help you better understand what we mean. Let’s imagine for a moment that we have two potential investments available, both in bonds (debt). The first is in euros, has a maturity of one year and pays a coupon of 3%. The second investment is denominated in euros and also has a maturity of one year but pays a coupon of 5%.
Which one would you choose? Seems obvious, right? Without thinking twice, you’d pick the second option where at the same maturity it pays you a higher coupon (5%). Nevertheless, if we throw in more information and tell you that in the first investment the debt is issued by the German government and in the second by the Venezuelan government, many of you would also most likely change your mind (considering the credit risk profile of the issuer apart from simply looking at the yield).
Well, exactly the same is true for ‘‘Capital-Guaranteed’’ products. You have to think about the issuer as the product is “Capital Guaranteed by the issuer” and getting your money back at maturity depends on the issuer’s solvency. As with debt, the return on the capital-guaranteed product may vary with the credit risk of the issuer. So it is crucial to check the issuer of the product you are being offered and not be dazzled by the magic words: “Capital-Guaranteed”.
Another significant factor to consider is the time horizon. This type of product is designed to be held to maturity. Although market practice allows the product to be sold before maturity, its liquidity is limited. The only way to cash out the product early is to sell to its manufacturer/issuer. Bear in mind that this type of product tends to have a more limited secondary market and higher price volatility compared to conventional debt securities. Its price varies over the life of the product due to various factors: issuer credit risk, changes in interest rates, changes in currency exchange rates, changes in the price of the underlying asset, the intensity of the price changes known as volatility and more. This means that the early sale price may be lower than the purchase price. Consequently, if you unwind the investment before maturity, you may not get back all the money you invested. It seems fair to say, then, that the capital is not actually fully guaranteed until maturity.
So when we talk about these kinds of investments, instead of (magically) calling them Capital-Guaranteed, it would be more accurate to call them by their proper name: “Capital Guaranteed by the Issuer at Maturity”.
