01. Cash investments & fixed‑interest securities Flashcards
Name 5 risks that apply to cash deposits?
- Default risk.
- Inflation risk.
- Interest rate risk.
- Reinvestment risk.
- Shortfall risk.
What is default risk?
Risk that the financial institution becomes insolvent and is not able to repay the investor’s capital.
What is inflation risk?
Risk of both capital and interest being eroded by inflation.
What is interest rate risk?
Risk of interest rate worsening e.g. negative interest rates.
What is reinvestment risk?
Risk that it may not be possible to secure the same higher level of interest on reinvestment.
What is shortfall risk?
Risk that the investor’s investment objectives, e.g. saving for retirement, will not be met due to lack of capital appreciation.
What is the maximum compensation payable under the FSCS to cash depositors?
Up to 100% of the first £85,000.
Regarding FSCS compensation, the golden rule is not to have more than £___ with any one ___.
- £85,000
- institution
The FSCS target is for most depositors to be paid compensation within ___ days and the remainder within ___ working days.
- 7 days
- 20 working days.
What are 3 common dangers of investing in an offshore account?
- High interest rates may seem attractive, but are usually offered by high inflation countries with potentially collapsing currencies.
- Strong currencies do not strengthen continuously against sterling: they fluctuate. Currencies regarded as strong may not rise enough to compensate for their lower interest rates.
- May not be the same level of supervisory structure as the UK, meaning institutional collapse may be more likely.
What are the two types of restricted access account?
- Notice accounts.
- Term deposit accounts.
Structured deposits pay interest based on the performance of what?
An equity index (usually the FTSE 100).
The typical structure for structured deposits offers the investor a return over a fixed term, which is the greater of what 2 things?
- Their original investment; or
- A % (e.g. 110%) of the change in the FTSE 100 [a bet].
Structured deposits tend to require a commitment of how many years?
5 years or more.
Name 2 risks associated with structured products?
- Inflation risk (cash element).
- Counterparty risk (derivatives element).
To transfer from cash ISAs to stocks & shares ISAs or vice versa, individuals must be aged ___ or over.
18 years
When can investors contribute into Help to buy ISAs until?
30 November 2029.
Which NS&I products are tax-free?
Premium bonds.
ISAs.
Certificates.
Kids ISAs (JISAs).
NS&I Guaranteed Income & Growth Bonds have the following characteristics:
- investors must be aged ___ or over;
- there is a fixed term of ___ year;
- the minimum investment amount is £___;
- interest is paid ___ but is ___ and can be set against the ___.
- Income bonds paid ___ a month.
- 16 years
-1year - £500
- gross / taxable / PSA
- once
Green Savings Bonds have the following characteristics:
- investors must be aged ___ or over
- issue 4 fixed interest of ___%
- ___ year fixed term
- invest up to a total of £___ per person
- interest is added on each ___
- interest is paid ___ but is ___ and can be set against the ___.
- 16 years
- 4.20%
- 3 year
- £100,000
- anniversary
- gross / taxable / PSA
What are the 3 main types of securities that are traded in the money markets (wholesale)?
- Treasury bills.
- Commercial bills.
- Certificates of deposit.
Why are Treasury bills issued by governments?
To finance government’s ST cash needs.
Who manages the issue of Treasury bills?
DMO.
Treasury bills are routinely issued at ___ by ___ and can have maturities of up to ___.
- weekly auctions
- the DMO
- 12 months.
What is the minimum requirement for the purchase of nominal treasury bills by an individual?
£500,000 nominal of bills.
Do treasury bills pay interest?
No, they are priced at less than their par and at maturity the govt. pays the holder the full par value.
What are certificates of deposit (CDs)?
Receipts from banks for deposits placed with them.
CDs carry a ___ rate of interest, usually related to ___.
- fixed
- SONIA.
CDs have a ___ term to maturity but can be ___ in the money markets which makes the yields on CDs slightly ___ than on ordinary deposits.
- fixed
- traded
- less
Most CDs are issued with maturities of __ to ___, with the interest paid on maturity.
1 to 3 months
What are commercial bills?
ST negotiable debt instruments issued by companies to fund their day-to-day cash flows.
Is the market for commercial bills more or less liquid than the market for treasury bills?
Less.
Commercial bills are issued at a discount to their maturity value, with typical maturities of what?
Between 30 & 90 days.
Name 2 types of money market fund and briefly describe them.
-
Short-term money market fund:
weighted average maturity of no more than 60 days and a weighted average life of no more than 120 days. -
Standard money market fund:
aim to make slightly higher returns by investing in assets with extended maturity periods of six and twelve months.
Fixed-interest securities are issued by governments, companies and other official bodies as a method of raising money to finance what?
Their longer term borrowing requirements.
How long do fixed-interest securities typically run for?
Between 2 to 30 years.
Name 3 reasons why companies often raise long-term finance by issuing bonds rather than borrowing from banks.
- Bond market offers a wide range of lenders to tap into.
- Bonds are often the cheapest method of borrowing money.
- Banks may not be prepared to lend the amount required.
What are 3 common characteristics of bonds?
- Fixed rate of interest, known as the coupon.
- Fixed redemption value, known as the par value.
- Are repaid after a fixed period, at the redemption date.
The title of a bond will always give three key features:
- Issuer’s name.
- Coupon.
- Maturity date.
A bond coupon is calculated as interest on what value of the bond?
The nominal value.
How often do most bonds typically pay interest?
Twice a year.
What is the “clean price”?
The price before accrued interest is added.
What is the “dirty price”?
The total amount paid by a purchaser, which is the clean price plus or minus any interest adjustment.
When a bond with cum dividend is purchased, what price does the buyer have to pay?
The “dirty price” i.e. the clean price plus the interest that has accrued from the date of the last interest payment up to the settlement date.
“Dirty price” cum dividend purchases: who gets the next interest payment and who gets compensated?
- The buyer gets the next interest payment.
- The seller for the interest to which they were entitled but did not receive.
“Dirty price” ex dividend purchases: who gets the next interest payment and who gets compensated?
- The seller gets the next interest payment if the sale is within a week of the interest payment date.
- The seller compensates the buyer.
Bond purchases ex div: Interest in respect of the period for which the buyer owned the bond, but which was paid to seller, is ___.
deducted from the clean price.
What is the primary market?
Where the arranging and selling of original issues of bonds takes place.
What is the secondary market?
Once a bond has been issued, where any subsequent trading takes place.
What are 4 major markets where substantial bond trading activity in the UK takes place?
- Government sector.
- Corporate sector.
- Sterling loans to foreign borrowers.
- Eurobond market.
What is a Eurobond?
An international bond, denominated in a currency other than that of the country where it is issued.
What does the interest yield (aka “running/flat/current yield”) measure and what is its formula?
The income return an investor receives on the amount paid for a bond.
(Coupon / clean price) x 100
The redemption yield is a more accurate calculation of the yield on a bond as it takes into account what 2 things?
- income payments from a bond; and
- the capital gain or loss from holding the bond until maturity.
What is the redemption yield formula?
Interest yield + or - (Gain or loss to maturity / no. of years to maturity) / Clean price x 100
What is the most useful measure of a bond’s return and why?
The redemption yield as it reflects the returns from both the interest & final redemption payments.
What is the tax perspective on gilts for:
- CGT
- Income tax
- No CGT if held directly).
- Taxable at marginal rate.
In addition to interest rate risk, inflation risk, default risk, name 2 other key risks associated with bonds.
- Currency risk.
- Liquidity risk.
What is currency risk?
Movements in exchange rates affect the value of the holding.
What is liquidity risk?
Many bonds trade infrequently and so can be difficult to sell them readily at an acceptable price.
When interest rates rise, what will happen to the following & why?
- bond prices
- yield
- falls (due to reduced demand)
- rises (as the coupon is fixed)
Volatility will be greater for bonds with ___ coupons and ___ periods to redemption
- smaller
- longer
What does the duration of a bond measure?
The sensitivity to interest rates.
What is the modified duration?
The expected change in a bond’s price given a movement in interest rates.
If inflation or interest rates rise, bond prices tend to do what?
What type of bond is the exception?
- Fall.
- An index-linked bond, where the value will rise with any increase in inflation.
What happens to bond values in:
- A period of economic growth?
- A recession?
- Economic growth can fuel inflation, —> rising interest rates, declining bond values.
- If an economy is in recession, interest rates may be reduced to stimulate a recovery, bond prices rise.
If a company’s credit rating is marked down, the market price of its bonds will ___ because they are seen as riskier investments, and investors will require an ___ yield to compensate.
- fall
- increased
What 2 categories do credit ratings broadly fall into?
- Investment grade bonds: BBB or higher (S&P), Baa3 (Moody’s) - lower default risk.
-
Non-investment grade bonds:
Below BBB/Baa3 - higher default risk. “Junk bonds” / Sub-prime.
What are the 3 main types of yield curve?
- Normal.
- Flat.
- Inverted.
What does a normal yield curve look like?
In normal circumstances, investors demand higher yields for holding longer-term bonds to cover the increased uncertainties over time. The yield curve is then a rising positive curve.
When does a flat yield curve occur?
When economic factors are deemed stable, and no radical changes to inflation and interest rates are expected.
What happens when a yield curve inverts?
The yield on longer-term bonds is less than on short-term bonds.
When can an inverted (reverse) yield curve occur?
This can be caused by investor expectations that interest rates will fall in the short-term, while long-term interest rates are expected to be below current levels.
Categories of gilts (DMO / financial press definitions) according to their time to redemption:
- Shorts
- Mediums
- Longs
- < 7 yrs / < 5 yrs
- 7-15 yrs / 5-15 yrs
- > 15 yrs
Index-linked gilts issued before September 2005 use ___ whilst those issued from September 2005 use ___.
- RPI 8 months before each payment date
- RPI 3 months before each payment date.
Index-linked gilts impact both the __ and the ___.
- coupon
- redemption value.
Who often favour longer-term gilts [2] and why?
- Pension funds.
- Life assurance companies.
- To match their longer term liabilities.
What is the repo market?
“Repo” is short for sale and repurchase agreement, at an agreed price.
What is the “strips” market?
“Separate trading of registered interest and principal securities”.
What is “stripping”?
The process of separating a conventional interest-bearing gilt into its individual interest (coupon) and redemption payments, which can then be separately held and traded in their ownright.
Do corporate bonds generally offer higher or lower yields than gilts?
Name 2 reasons why.
- Higher.
1. Higher credit risk (potential insolvency unlike a govt.)
2. Also market generally less liquid therefore higher return expected.
Secured corporate bond loans rank ___ unsecured loans in the event of the company being wound up.
before
When a corporate bond loan is unsecured, where will the holder rank for repayment?
Alongside the ordinary creditors of the company.
Why may companies favour the corporate bond market to raise capital over banks? [3]
- often a company’s cheapest method of borrowing money
- wider pool
- banks may not be keen to lend
What is a debenture?
A secured loan agreement between a lender and a borrower with business assets used as security.
What 3 things will a debenture agreement include?
- the interest rate, payment dates and redemption date.
- the assets backing the debenture.
- any conditions imposed on the borrower.
What is:
- a fixed charge: and
- a floating charge?
- A fixed charge is a charge over a specified asset or assets of the company, e.g. land where fixed-charge asset.
- A floating charge is a general charge over any of the assets of the company that are not otherwise secured in favour of other lenders or banks:
How do fixed and floating charges differ? [3]
- Fixed-charge assets cannot be sold by company without consent of debenture holder.
- Company can freely dispose of floating-charge assets but these assets can be sold to repay debenture holder if it defaults on loan.
- A floating-charge debenture has a lower priority for payment if co. wound up.
What are convertible bonds?
Usually unsecured loan stock that offer the holder the option of converting the bond into the ordinary shares of the issuing company under specified terms and conditions.
Convertible bonds usually carry a ___ coupon than straightforward loans because of the right of conversion into ordinary shares at some future date.
lower
Convertible bonds ___ qualify for exemption from CGT and losses___
- do not
- can be set against other taxable gains.
What are floating rate notes (FRNs)?
Bonds issued by companies, esp. banks and other financial institution including governments, which pay a rate of interest not fixed but instead linked to a money market rate, such as SONIA.
How often is the coupon reset for FRNs?
The coupon is reset every quarter to a specified level over the reference rate, e.g. SONIA.
What are PIBS and what are they?
- Permanent Interest Bearing Shares.
- Loans to building societies with no redemption date and never-ending coupons.
What are PSBs and what are they?
- Perpetual Subordinated Bonds (think Pet Shop Boys!).
- PIBS after demutualisation.
Name 3 features of PIBS / PSBs.
- Undated.
- Lowest in pecking order in insolvency.
- Non-cumulative.
The AMC of money market funds is likely to be in the region of ~.
0.15%
What are the rules when transferring ISA money saved in the current tax year?
Must be for the whole amount saved in that tax year up to the date of transfer.
Gilts are referred to as ~~~ as they pay no regular half-yearly interest.
zero coupon instruments
What will happen with index-linked gilts to the interest & capital payments if RPI falls?
They will also fall.
