How do "Guaranteed" Equity Bonds Work?

Guaranteed equity bonds offer assurance against loss in the long run. The term "equity bond" is a bit confusing. A bond typically implies no equity is at stake, whereas a stock uses equity. An equity bond mixes the two concepts. It tracks a given stock index, and it pays out based on the growth in that index over time. Guaranteed equity bonds add an additional component. The issuers of these bonds promise to repay the debt or a portion of the debt regardless of the performance of the bond. 

Advantages of Guaranteed Equity Bonds

Guaranteed equity bonds are offered by private corporations, investment houses and even hedge funds. They often serve as an alternative to buying into a mutual fund or CD with a traditional investment house. The main advantage of a guaranteed equity bond is limited exposure to risk. This low risk level appeals to some novice investors would like to start engaging the equity markets but are afraid of aggregated risk exposures inherent in the equity markets. With the guarantee on these bonds, these investors will not have to take the risk in order to step into the market. They are never actually purchasing any equity itself. Instead, they are purchasing a bond from a corporation that will go purchase the equities, or other equities.

A bond, by definition, cannot fail to pay the initial investor. A guaranteed bond takes this one step further, providing the ultimate payoff as a definitive number up front. For example, a guaranteed equity bond (GEB) may promise 50% return regardless of market performance. If the bond is issued at $100 for a 5-year maturity, the investor is guaranteed to receive at least $50 in return, even if the investment ultimately fails completely. This is still not a gain, but it is protection from total loss. 

Disadvantages of Guaranteed Equity Bonds

The term guaranteed tricks many investors into thinking there is a guaranteed profit, which is rarely the case. In fact, few GEBs actually promise to repay the initial investment 100%. In the example above, the investor still lost 50% of her investment. Even in the cases where 100% return is promised, this does not compensate for inflation, which can greatly negate any earnings over time.

Even though the guarantee does not promise full safety, it is still extremely costly. GEB products rarely provide dividends during the time they are active. Further, just as losses promise to be moderate, earnings are often moderate as well. Even if the stock index a GEB is tracking goes up substantially over time, an investor does not make an amount equal to this gain. Instead, the gain is often calculated as an average gain over the life of the GEB. Ultimately, this means the GEB will typically post returns reflecting total market swings during the time it is active. The investor may have been wide in electing certain equities, but their sharp growth in his portfolio is countered by the moderate growth of other equities in the GEB.

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