What is a Capital Guarantee?

A capital guarantee is an assurance that the investor will be able to recoup all or at least part of the initial investment, at the time that the investment vehicle reaches maturity. This type of guarantee is usually extended by the institution that issues the security, and serves as a means of attracting attention from investors who otherwise may not be interested in purchasing that security. While this type of guarantee does tend to reduce the risk that the investor assumes, it can also minimize the amount of return that can be expected from the security.

There are a number of different forms that a capital guarantee can take, depending on the type of investment involved. Bond issues are sometimes crafted to include what is known as a bond plus option, which includes the assurance that the investor will recoup at least the initial investment if the issuer chooses to call the bond early. With loans, the capital guarantee may be included in what is known as a letter of guarantee, essentially assuring the lender that he or she will recoup the original face value of the loan at a minimum, although no promises regarding the applied interest is included in that guarantee. Various types of guarantees similar to these may be used in venture capital situations, or any other type of transaction where some type of return along with the principle is anticipated at some point in the future.

While the capital guarantee does ensure the investor that at least a portion of that original investment will be returned eventually, there is a price to pay for that type of assurance. Often, the structure of the guarantee places limits on the potential return that may be earned by that initial investment. For example, a bond issue that includes a capital guarantee may carry a lower rate of interest than a bond with no guarantee. In addition, that guarantee may also specify a different interest rate if the bond is called early. Both scenarios are to the benefit of the issuer, since they make it possible to have more funds on hand to honor the guarantee if necessary, while still placing relatively little stress on their available resources.

As with any type of investment opportunity, investors should look closely at the terms and conditions that apply to the purchase of any security. If there is a capital guarantee including in those provisions, it is important to understand exactly what is being guaranteed, what events must take place to trigger the guarantee, and how much return of the initial investment and any other return can reasonably be expected. Considering these factors along with the potential return on the investment if the guarantee is not invoked will make it much easier to choose investments that fit the financial goals of the investor.