Performance guarantees

If you’ve studied for other securities exams, you’ve probably noticed how sensitive the word “guarantee” is. In most situations, using it suggests an unethical and/or illegal practice. That same caution applies on the Series 63.

There is one legitimate use of the term, though: a guaranteed security.

A security is considered guaranteed when a third party (usually an insurance company) agrees to pay any unpaid interest, dividends, and/or principal if the issuer can’t.

That guarantee does not mean an investor can’t lose money. The third party covers only what it guarantees (interest/dividends/principal). It does not protect the security’s market value.

For example, assume an investor buys a bond with $1,000 principal (par) for $1,200. If the bond defaults (meaning the issuer can’t repay the borrowed funds), the insurance would cover only the $1,000 principal and any unpaid interest up to that point. The extra $200 the investor paid above par would not be covered.

*The specifics related to bonds and other securities are generally not tested on the Series 63. You should know what the term ‘guaranteed security’ refers to and what’s covered by the third party. The exam typically doesn’t go much further than that.

Outside of guaranteed securities, the term “guaranteed” is usually tied to unethical conduct. In particular, financial professionals must never guarantee that a security will perform in a certain way. This includes:

• Guaranteeing a client will make a return
• Guaranteeing a client will not lose money
• Refunding any transaction or advisory fees for bad performance

One defining characteristic of a security is the possibility of loss. Because of that, performance guarantees and securities don’t mix. Even if a guarantee against loss sounds appealing, it isn’t feasible for broker-dealers, agents, investment advisers, or investment adviser representatives (IARs) to offer them.

A guarantee can also create serious financial risk. If a registered person promises more than they can actually cover, the firm could be exposed to large losses - especially during a major bear market (e.g. the Great Recession). For that reason, financial professionals should avoid performance guarantees entirely.