Performance guarantees

If you’ve studied for a securities exam other than the Series 65, you’ve probably noticed how sensitive the term “guarantee” is. In most situations, using it can suggest an unethical and/or illegal practice. The same caution applies here.

There is one context where the word can be used appropriately and legally: guaranteed securities.

A security is considered guaranteed when a third party (usually an insurance company) promises to cover any unpaid interest, dividends, and/or principal.

It’s important to separate what’s guaranteed from what isn’t. A guarantee covers the promised payments, but it does not protect an investor from losing money due to changes in market value.

For example, suppose an investor buys a bond with a $1,000 principal (par) value* 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 65. 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 associated with unethical activity. 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. That’s why 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 one. If a registered person guarantees more than they can actually cover, the guarantee can threaten the financial stability of the firm - especially during a major bear market (e.g., the Great Recession). For that reason, financial professionals should avoid performance guarantees.