1 - Cash and Fixed Interest

Question 1

What are the 4 risks of investing in cash/savings accounts?

Answer 1

_Cash/Savings account risk_s

Credit/counterparty risk (bank goes bust, but FSCS protection)

Inflation

Interest rate risk (reinvestment risk)

Exchange rate risk (foreign savings only)

Question 2

What is the nominal rate on savings?

Answer 2

The nominal rate is the advertised rate.

If interest is paid annually this is the same as the AER.

However if interest is paid (i.e. compounded) more regularly, the periodic interest rate is the nominal rate divided by the number of periods.

E.g. nominal rate of 10% on a monthly account, means interest is paid every month at a rate of = 0.10 / 12 = 0.0083333 (or 0.8333%).

Question 3

What is the AER on savings?

If nominal rate is 5% and interest is paid monthly, what is the AER?

Answer 3

AER is annual equivalent rate

This is the rate you are effectively getting over a whole year as a result of compounding.

Periodic (monthly) interest rate = 0.05/12 = 0.0041667

Multiplication factor = 1 + 0.0041667 = 1.0041667

Applied over 12 months = (1.0041667)¹² = 1.05115 (so 5.115%)

Question 4

Is the AER higher or lower than the nominal rate?

Answer 4

AER is always higher than the nominal rate (unless interest is paid annually, then they are the same).

This is because AER takes into effect the added value of compounding (extra interest on your interest) which increases how much you get paid over a whole year.

Question 5

If the nominal rate is the same, would you prefer daily, monthly or yearly interest payments?

Answer 5

The more regular the interest payments are, the bigger the compounding effect and the more added interest on interest you will get over the year.

So daily is better than monthly, which is better than quarterly, which is better than annually.

Question 6

If I invest £50k at 4% for 6 years, how much will I end up with?

Answer 6

£50,000 * (1.04)⁶ = £63,265.95

Question 7

If I need to buy a car in 3 years for £20k and my bank is paying me 6.5% interest, how much do I need to put in the bank today?

Answer 7

Calculate the growth factor first

(1 + 6.5%)³ = (1.065)³ = 1.20795 (write the answer down on scrap paper!)

Now divide the amount you need by the growth factor

£20,000 / 1.20795 = £16,556.98

Question 8

Help to buy ISAs

What are the limits?

What is the benefit offered?

What can you spend the funds on?

Answer 8

Help to buy ISAs

You get a bonus of £50 on every £200 you invest

Max you can invest is £12,000 (so £3,000 max bonus) in total

Maximum initial investment of £1,000, maximum monthly investment of £200

Can spend up to £450k on London house, £250k outside London

Question 9

NS&I products

What are the tax free NS&I products?

Answer 9

NS&I tax free products

• Direct ISA
• Premium Bonds
• Fixed Interest & Index-linked savings certificates (5 year term)
• Children’s bonds (up to age 21, 5 year terms)

Question 10

NS&I Products

Taxable NS&I products

Answer 10

Investment Bonds

• Guaranteed Growth Bonds (1, 3 or 5 yrs)
• Guaranteed Income Bonds (1, 3 or 5 yrs, no longer on sale)
• Income Bonds

Savings Accounts

• Investment Account (postal)
• Direct Saver (online or phone)

Question 11

What are the age restrictions for NS&I products?

Answer 11

Other than the Children’s Bond everything is 16+.

Children’s Bond can be opened up to 16 years old and they have a 5 year term, so you can have them up until the age of 21 potentially.

Question 12

Money Markets

What are they, how can I invest?

Answer 12

Money markets are short term (almost cash) debt securities used by banks/gvmt/business to borrow money.

Not really for retail guys, but you can invest via Money Market Funds (which can be included in your cash ISA!).

Question 13

Money Markets

Three types and how they pay returns

Answer 13

T-Bills (treasury bills) - Issued by government at a discount

1, 3 or 6 month maturities

Certificates of Deposit (CoDs) - Issued by banks, pay interest at maturity

Commercial Bills/Paper - Issued by companies at a discount

Question 14

Fixed Income/Bonds

Which of these bonds has a higher yield?

Government Bond

FTSE 100 company corporate bond

AIM listed company corporate bond

Answer 14

Investors demand higher yield to reflect higher risk, therefore the AIM company will have to pay the highest yield to attract investors.

Question 15

Fixed Income/Bonds

How do changes in the economy or the real world impact bond prices?

Answer 15

First question is always: What is happening to interest rates?

If interest rates go up investors will demand higher yield from all bonds in the market.

Since bond coupons are fixed, the prices of bonds on the market have to fall so that the yield goes up to make investors happy.

Question 16

Fixed Income/Bonds - Clean Prices

What is the difference between clean and dirty prices?

Which price appears in the FT?

Which price will I pay when I call my broker to trade?

Answer 16

The difference between clean and dirty prices is the accrued interest (which is zero the day after an interest payment and equal to the coupon the day before the coupon payment).

The FT prints the clean price, since this is the clean and tidy number than people can use to compare one day to the next.

The real world is dirty, so you have to pay the dirty price! If the coupon is paid tomorrow you have to pay for it because you’re the one who receives it.

Question 17

Fixed Interest/Bonds

What do the terms cum and ex mean?

Which is higher?

Answer 17

Cum means the dividend/coupon has not yet been paid, Ex mean it has (think about ex-boyfriends, they’ve gone!).

So when a bond/share is cum-dividend, the price is higher, because if you buy it then you will receive the dividend.

When the bond/share is ex-dividend the price will drop, because the guy you’re buying it off will receive the dividend (even if it hasn’t been paid yet).

Question 18

Fixed Income Calculations

If the coupon on a bond is 7%, clean price is £96.20 and the dirty price is £97.70, what is the interest yield?

Answer 18

Interest Yield = Coupon rate / Clean Price

= 7 / 96.20

= 7.28%

Question 19

Fixed Income Calculations

If the clean price of a bond is below par, and the coupon is 5%, will the interest yield be bigger or smaller than 5%?

Answer 19

It will be bigger, because you are receiving 5% of the par value (£5) but paid less than par for the bond (<£100) so you’re getting a higher return on your investment than the 5%.

Question 20

Fixed Income Calculations

For the following bond what is the gross redemption yield?

Coupon = 6%

Clean price = 103.20

Price paid for the bonds = 104.10

3.5 years to maturity

What if you are given 5% interest yield instead of 6% coupon?

Answer 20

GRY = (Coupon +or- (Gain or loss / # years to maturity)) / Clean Price

= (6 - (4.10 / 3.5)) / 103.20 = 4.83 / 103.20 = 4.68%

Or GRY = Intest Yield +or- (Gain or loss / # years to maturity) / Clean Price

= 5% - (4.10 / 3.5) / 103.20 = 5% - 1.14% = 3.86%

Question 21

Fixed Income/Bonds

What are the risks?

Answer 21

• Interest Rate Risk (if rates rise your bond value falls)
• Liquidity (some are hard to sell)
• Inflation (value of your fixed future payments falls, UNLESS index linked)
• Exchange rate risk (if in a foreign currency)
• Default risk (this is specific to bonds)
• Market/systematic risk (general economic stuff will affect bonds)

Question 22

Fixed Income/Bonds

What are the DMO definitions of short/medium/long term?

Answer 22

Short - 0 to 7 years

Medium - 7 to 15 years

Long - Over 15 years

Question 23

Index Linked Gilts

Are the interest payments or capital repayment linked to RPI?

Do you get a higher or lower yield than a normal bond?

What is the tax treatment?

Answer 23

BOTH interest payment and capital are linked to RPI.

Yields will be lower than on normal bonds to offset the benefit of RPI growth.

Tax is just like normal bonds, no CGT but income tax on the interest payments.

Question 24

Corporate Bonds

How do the following compare to government bonds?

The yield

Volatility of bond prices

Liquidity

Spread and dealing costs

Credit/default risk

Answer 24

Yield on corporate bonds is higher due to the higher risk.

Volatility is higher due to the higher risk.

Liquidity can be lower, especially for smaller companies

Bid/offer spread when trading will be wider, costs are higher.

Credit/default risk is higher.

Question 25

_Fixed Interest/Bonds_ What is a floating rate note?

Answer 25

A floating rate note pays a coupon that changes over time. Based on LIBOR, which is a published interest rate than changes every day. Instead of paying a fixed coupon every 6 months, the bonds pay the LIBOR rate, plus a fixed amount. EG if the bond pays LIBOR + 2% and the libor rate is 2.5%, then the bond will pay 4.5% (actually will pay half of that because it's paid 6 monthly).

Question 26

_Permanent Interest Bearing Securities_ What are they? Do they participate in performance (i.e. divs like shares)? Are they cumulative? Tax?

Answer 26

PIBS issued by building societies when they convert into banks. They pay fixed interest amounts, not dividends based on profits. Interest is not cumulative, paid every 6 months. Do not pay CGT. So overall very similar to bonds, except they rank after all other bonds in the event of default (so similar to shares in that respect).

Question 27

_Fixed Interest/Bonds_ What is the duration of a bond?

Answer 27

Duration is the average time it will take to get the cash payments from a bond. If the maturity is 10 years then the duration will be less than 10 years as some of the payments (i.e. the coupons) will be received sooner.

Question 28

_Fixed Interest/Bonds_ If a bond has higher coupons will it have a longer or shorter duration?

Answer 28

High coupons lead to a short duration. Remember that for a zero coupon bond the duration is equal to maturity as there is only one payment at maturity. As coupons get bigger they have a bigger impact on the average time to receive your cash, so the duration decreases.

Question 29

_Fixed Interest/Bonds_ Which of these types of bond will have the biggest exposure to interest rates? * A longer or shorter dated bond * A bond with higher or lower coupons * Longer or shorter duration

Answer 29

* The longer the maturity of the bond the more sensitive it is to interest rates. Remember that if your bond expires tomorrow you don't care what interest rates are, but if it has many years left you're still very exposed. * The bigger the coupons the less exposed you are to interest rates, because duration decreases (see next point). * The same as with maturity, the shorter the duration the less senstivity you are to interest rates. The sooner you get hold of your cash the sooner you can re-invest at market interest rates, if your money is stuck in the bond for longer you are stuck with your contracted rates for longer.