Providers of ‘capital guaranteed’ and ‘capital protected’ structured products usually promise to at least repay your original investment at the end of a stated period. However, the nature of the protection varies, and some products have clauses and performance hurdles that may even lead to losing your capital.
What are capital-guaranteed and capital-protected products?
Structured products promoted as having capital guarantee or capital protection typically combine a ‘safe’ and a ‘risky’ asset into one product structure.
For example, a safe asset, such as a bond, enables the issuer to promise the return at maturity of at least some or all of the investor’s original investment. This feature is promoted as ‘capital protection, or sometimes the ‘capital guarantee.’
These assets may be packaged with a risky derivative investment such as options. The derivatives are used to create some level of participation in the performance of shares, commodities, or other assets. The value of the investment at maturity depends on the performance of these ‘reference assets.’
This is an example of how one of these products may be structured. Other products may have different asset class exposure and terms and conditions that apply to your capital repayment and investment returns. These differences make it difficult to compare these products.
Capital-guaranteed and capital-protected structured products should not be confused with more conservative investments that may also be described as ‘protected’ or ‘guaranteed.’ This includes life insurance annuities, saving accounts, and term deposits with regulated banks, corporates, and government institutions.
Types of Capital Protection Products
Capital protection products usually consist of two elements. The first element offers capital protection at maturity. For example, this can be a money market or fixed-interest investment. The amount of the capital protection is determined by the issuer at issuance and stated as a percentage of the par value. The capital protection may be below 100 %, depending on the product specifications and design as a rule: the lower the capital protection, the higher the earnings potential. The second element is participation in risky asset classes. This can be an equity asset class or a riskier underlying asset like derivative products. The combination allows the investor to participate in the development of one or more underlying assets and, at the same time, limit the risk of loss.
Types of Structured Products with Capital Protection
The following product types can be designed with absolute or conditional capital protection.
- Capital protection without a cap: Repayment at maturity is at least in the amount of the capital protection. The investor profits without limitation and under consideration of the price increase of the underlying assets.
- Capital protection with a cap: Repayment at maturity is at least in the amount of the capital protection. The investor profits under consideration of the participation up to a pre-defined value (cap) in the price increase of the underlying assets. The profit potential is limited to the amount of the cap.
- Conditional or unconditional capital protection: With investments with unconditional capital protection, the investor profits upon maturity from the guaranteed minimum repayment in the amount of the capital protection. With conditional capital protection, the protection applies up to a pre-defined threshold value. If this value is reached, the capital protection is lost.
Examples: Capital Protection Investment Products
Example 1: The capital-protected value is 100%
The capital protection is 100% of the invested amount. This means that after the stated period, say six years; the investor will receive at least the protected value of Rs 100,000. Suppose the investment allocation in the stock index is 50%.
Scenario: The price of the underlying asset increases; suppose the stock index has increased by 30% on the maturity date compared to the initial price. The additional payment after six years would be 15,000 euros (50% x 30% of the investment amount). At maturity, the investor will receive Rs 115,000 (the capital protection value plus the additional payment).
Example 2: The capital protected value is 100% and a cap of 150%
The capital-protected value is 100%, and a cap at 150% Suppose the investment allocation in the stock index is 75%. Then, the estimated return at maturity will at least be the capital-protected value of Rs 100,000. Assuming the stock index increases on the maturity date compared to the initial value. Then, the investor will receive an upside in the index rise on top of the capital-protected value up to a maximum of 50% (cap).
Scenario 1: the price of the underlying asset increases. Suppose the stock index increases by 30% on the maturity date compared to the initial price. The additional payment would be 22,500 euros (75% x 30% of Rs 100,000). At maturity, the investor will receive a total of 122,500 euros (the capital-protected value plus the additional payment).
Scenario 2: the price of the underlying asset increases above the cap. Suppose the stock index increases by 60% at the maturity date compared to the Initial value. This is higher than the cap. As a result, the additional payment would be Rs 37,500 (75% x 50% of Rs 100,000) and not Rs 45,000 (75%*60%*Rs 100,,000). At maturity, the investor will receive a total of 137,500 euros (the capital-protected value plus the additional payment).
Scenario 3: the price of the underlying asset is equal to or decreases compared to the Initial price. Suppose the stock index decreases or remains similar to the initial value at the maturity date. At maturity, the investor will only receive the capital-protected value of Rs 100,000 (the initial investment amount x 100%).
Example 3: The capital-protected value is 95%
The protection value after six years is Rs 95,000 (initial investment amount x 95%). Suppose the participation rate in the stock index is 90%. Then, the estimated return at maturity will be at least the capital-protected value of Rs 95,000. Assuming the index increases on the maturity date compared to the initial value. The investor will receive an upside in the index rise. However, for a positive return, the underlying asset in this example must first make up for the difference between the initial investment (100%) and the capital-protected value (95%).
Scenario 1: the price of the underlying asset increases by more than 10%. Suppose the stock index increases by 30% on the maturity date compared to the starting value. The additional payment would be Rs 27,000 (90% x 30% of the initial investment in the stock index, i.e., Rs 100,000*90%*30%). At maturity, the investor will receive Rs 122,000 (Rs 95,000 capital-protected value plus Rs 27,000 additional payment).
Scenario 2: the price of the underlying asset increases by less than 10%. Suppose the stock index increases by 5% on the maturity date compared to the Initial price. The additional payment is Rs 4,500 (90% x 5% of the investment in the stock index). At maturity, the investor will receive Rs 99,500 (Rs 95,000 capital-protected value plus Rs 4,500 additional payment). This is Rs 500 less than the invested amount.
Scenario 3: the price of the underlying asset is equal to or decreased compared to the Initial index value. Suppose the stock index is equal to or has reduced at the maturity date compared to the initial value. At maturity, the investor will receive only Rs 95,000 (capital-protected value). This is Rs 5,000 less than the initial investment amount.
Could any investment be guaranteed?
Labeling or describing these structured products can create a perception of safety that, in some cases, is inconsistent with the product’s features and risks. Significant conditions are often associated with the ‘guarantee’ or ‘protection.’
Some products promise that you should get back at least the initial investment even if financial markets turn downside. For example, a capital-protected investment linked to the top 100 shares on NSE may pay investors a return of 20% of the cumulative growth over five years. The promise is that even if the index makes a cumulative loss over this time, you will still get back the original amount you invested at the end of the five years.
But no investment is 100% secure. In certain extreme circumstances, for example, if the company providing the guarantee goes belly-up, you can still lose money with these investments.
Before you invest, make sure you understand the return being offered and whether it will compensate for the risks, and what, if anything, is being protected.
Weigh up the benefits and risks of capital-guaranteed investments
Even if you are confident of the security of the guarantee or protection, you need to weigh up the cost of the product against the benefits it can provide.
Structured products vary from short-term to long-term investments (approximately 1 to 10 years). Early redemption may be possible. However, break costs (based on the embedded derivative’s current ‘mark-to-market value), exit fees, and cancellation of the capital protection feature also often apply. Some issuers only allow redemptions every month; in some cases, redemptions can take 6 to 8 weeks.
Any capital-protected investment linked to an investment market is usually only guaranteed or protected if you leave your money for a period (often 5 to 10 years). If you want to invest for this period, a diversified investment in equity shares may give you similar returns and cost you less.
While some structured products have a much shorter timeframe, for example, 1 to 2 years, capital may be at risk rather than protected. Inflation can also eat into your capital even if falling investment markets don’t.
Conclusion: Read the Investment Document Before You Invest in Capital Guarantee Products
Before you invest, read the investor guide. Investments promoting capital protection or guarantees might sound safe, but the labels can be misleading. They are more complex than many other investments, and the risks can vary between products.
With capital-guaranteed and protected products, higher promised returns usually come with higher risks. Therefore, it’s recommended that, before you invest, you take extra care to understand the nature and risks of these complex structured products. If you don’t know how investment and capital protection are structured and how promised returns are achieved, you should not invest.