1 - The characteristics, inherent risks, behaviour and correlation of asset classes. Part 1 - Cash investments and fixed interest securities. Flashcards
How are the values cash and fixed interest securities vulnerable?
The are eroded by inflation
Which type of investment is generally considered a loser in an economic downturn?
Equities
In periods of declining interest rates, which types of investments are most attractive?
Fixed interest bonds and equities
What are the different types of risks to investment capital and income?
Shortfall Systematic and Non-systematic Currency Interest Rate Liquidity Counterparty Regulatory Income Inflation
Why is it important for an investor to have an element of cash within their portfolio?
So its easily accessible in the event of an emergency
What are the key characteristics of cash investments?
Receive regular interest payments
The capital is not exposed to investment risk
There is no potential for capital growth
Is is called a liquid asset
What should an investor consider before entering into a fixed term cash deposit?
The penalty for withdrawal could outweigh the interest differential
A notice period/penalty would normally apply
What are the wider risks for deposit based investments?
Default risk - credit worthiness of the institution
Inflation risk - real return after inflation is negative
Interest Rate risk - Returns may vary over time
Note - for currency deposits, exchange rate movements could affect the rate payable and also impact on the overall capital
What elements does an investor need to consider regarding the FSCS for deposits?
The limits only apply to each investor
An investor with accounts across several providers cannot recover more than a person with all accounts in one place.
Joint account holders can each recover the maximum in respect of the same account
If accounts are held with subsiduaries, only the parent company is authorised and only for the first £85K
Why was there a reinvestment risk for savers in 2009?
Many had invested some 3-5 years before when interest rates were higher and therefore could not secure the same rate on reinvestment. This was particularly exposing for retired savers or others who relied on income from savings.
What are the common dangers of offshore accounts?
High rates are usually offered by hihg inflation countries with unstable currencies
Even strong currencies fluctuate, they may not rise enough to compensate for a low interest rate
There may not be the same supervisory structure as the UK and therefore institutional collapse may be more probable
What are the features of structured deposits?
Based on the performance of an index - such as FTSE
Risk free way to invest in the rise of stock markets
Generally require a commitment of 5 years
100% capital protection
What are the key features of an ISA?
Interest is paid tax free £20K limit Arranged on an individual basis Withdrawals can be made at any time Subject to provider rules, amounts can be replaced within the same tax year
What type of ISA transfers can be undertaken?
Some or all of savings from a previous tax year can be moved to a different ISA manager
Within the same tax year, all of the savings can be moved
ISA cash savers can move their money to another cash ISA or to stocks and shares/Innovative finance ISA
Stocks and shares ISA can be moved to a cash ISA
A help to buy ISA can be moved to a lifetime ISA
What are classed as eligible investments for ISA?
Bank and building society accounts
Units and shares in a UK unit trust and OEIC’s, UCTIS
Stakeholder cash deposits
National savings direct ISA
What are the minimum and maximum investment amounts in a National Savings Income Bond and Growth Bond and what term can they be over?
£500 minimum
£10,000 maximum
One or three years (two and five year terms are only availabe to customers renewing a maturing bond)
What is the simplest way a client could access the money markets?
Through a collective investment scheme
What makes use of the money markets attractive to banks, companies and governments?
The instruments are highly liquid and carry a relatively low risk
What are the money market instruments?
Treasury bills
Commerical bills
Certificates of deposits
Others - repos, bills of exchange
Who issues treasury bills and how is the rate of return evidenced?
Issued by the Government
The par/face value is less than the issue price, at maturity the Government pays the full par value, therefore the interest is the difference between the purchase price and the maturity value.
What would a certificate of deposit be used for and can they be cashed in early?
Used by Banks and building societies to raise funds.
They cannot be cashed in early but can be traded on the money markets but the yield would be slightly lower than the agreed rate at the outset (usually linked to LIBOR)
What are commercial bills and how do they operate?
Short term negotiable debt instruments
Issued at a discount to their maturity value
Unsecured, so only issued by companies with high credit ratings.
Yeilds higher than treasury bills due to the credit risk and reduced liquidity
How do managers categorise funds on the money markets?
Short-term funds - weighted average of maturity of no more than 60 days, weighted average life of no more than 120 days
Standard funds - periods extended to six - twelve months
What factors should be considered when deciding if money market funds are right for a client?
How the funds compare with other cash-based investments
What charges are made and how these impact returns
How long it will take to realise the assets if the client needs access
What assets are contained and the degree of risk exposure
How experienced the fund management team is
What is the general description of a fixed interest security?
Issed by Governments, companies or other official bodies to raise money/finance
The owner will receive regular fixed interest payments and usually repayment of capital at the end of the agreed period
Cannot be cashed in early, but the investor can sell them on the stock market at any time
Why are fixed interest securities also know as ‘negotiable fixed interest, long term debt instruments’?
They are
Negotiable - the lender can sell the entiltement to a thrid party, who can sell it on
Fixed interest - the borrower is committed to pay for the duration of the loan
Long term - run between 2 - 30 years
Debt instrument - financial instruments representing debt
What other names refer to fixed interest securities?
Bonds Loan Stock Debentures Loan Notes Gilts - issued by the government Corporate Bonds - issued by companies
Why would a company use a bond to raise capital, as opposed to a Bank loan?
May not be able to lend for the required period
Bond market offers a wider range of lenders
Often cheapest method of borrowing money
What are the three general characteristics of Bonds?
Coupon - fixed rate of interest
Par Value - redemption value
Redemption date - repaid after a fixed period
What are the three key features the title of a bond will give?
Issuers name
Coupon
Maturity date
Will also contain a nominal value of £100 (market value will differ) as the bond nears maturity it will approach the nominal value
How are Bonds priced?
Traded by their nominal/par value for £100
Nominal or par value determind by - the price at the which the bond will be redeemed by the issuer at the redemption date, the amount of interest received.
Why would the prices quoted within the FT and other newspapers, be different to the price an investor would pay?
They are mid-market prices
They are clean prices - ignoring interest accrued - which is calculated daily and added or subtracted to the clean price
What does Cum dividend mean in relation to Bond interest?
The purchaser will receive all 6 months interest
The buyer has to compensate the seller for the interest they did not receive
The buyer will pay the clean price, plus the accrued interest
What does the Ex dividend mean in relation to Bond interest?
Interest payments are made to the registered holder, seven days before due
If the bond is purchased after than time, before the due date, it is bought ex - the full interest will be paid to the seller
The clean price is adjusted to reflect this
How are bonds issued in the Primary Market
Large investors put in bids at the price and quantity they want
Successful bidders pay the bidded price
The can submit non-competative bids up to £500K and the stock is issued at the average of the accepted price
If a Bond was issued by an investment bank on behalf of organisations or companies - what is the issue process?
The issue is marketed to potential investors
Potential investors place bids
Final terms are agreed and issued, investors have 24 hours to make firm bids
Why is the secondary market of bond trading brisk?
Holders constantly adjust their holdings to reflect What income they need Credit ratings of issuers Future interest rate trends Changes to expected inflation Conduct of government finances International tensions - social and political Attractiveness of other assets
What are the four major bond markets?
Government
Corporate
Sterling loans to foreign borrowers
Eurobonds - named according to the country in which they are issued (in a different currency) - i.e. Eurosterling bond/eurodollar bond
What are the risks associated with bonds?
Interest rate risk - lower means greater value, higher interest rates means a falling value, therefore longer term bonds fluctuate more rapidly
Liquidity risk - can be difficult to sell readily at an acceptable price
Inflation risk - effect of erosion, however index linked bonds provide better protection as adjusted for inflation
Currency risk - movements in exchange rates
Default risk - issuer may not be able to meet their obligation to pay
What are the two categories of credit ratings for Bonds?
Investment grade - ratings of BBB- or higher (or Baa3) relatively low risk of default
Non investment grade - ratings of below BBB-(or Baa3) considered to have a significantly higher risk of default. (also known as junk bonds/high yield bonds)
What are the two factors affecting the volatility of bonds?
The lower the coupon the more volatile the bond
The longer the period to redemption, the more volitile the bond
What is the purpose of a yield curve?
Means of comparing yields on different bonds as well as giving an indication of the markets expectations in future
Why would a yield curve be inverted?
Investor expectations that interest rates will rise in the short term, and lower in future
Factors impacting supply and demand that reduce the yield on longer dated bonds
What are the three categories given to gilts by the DMO?
shorts - less than seven (five by the financial press)
Mediums - seven and 15 years (five and fifteen)
Longs - Over fifteen years (same in press)
How are investors protected by using Index Linked Guilts?
Interest payments revised in line with RPI
Capital repayment on redemption reflects changes in RPI
Note - if RPI falls, then both of the above will fall
If a guilt is stripped, can the interest element be traded seperately to the redemption payment?
Yes it can
What are the two types of corporate bond and what other restrictions might be in place for those issuing the bond?
secured or unsecured
An upper limit of borrowing
the company might need to stay within certain financial ratios
What is the definition of a Debenture?
A written acknowledgement of a debt
What would a trust deed for a debenture include?
Terms of issue - interest rate, payment dates and redemption date
Assets backing the debenture
Powers of the trustee
Any conditions imposed on the borrower
What are the two ways a debenture can be secured?
Fixed charge over a specified asset
Floating charge - a general charge over any of the assets of a company that are not otherwise secured elsewhere
Which would you prefer as a lender - a fixed or a floating charge and why?
Fixed - as the assets cannot be sold without authorisation of the debenture holder. Assets can be sold with a floating debenture and has lower priority for payment if the company is wound up.
What is a convertible bond and its characteristics?
Unsecured loan stock that can be converted into ordinary shares of the issuing company.
Interest is payable until the option is exercised, they carry a lower coupon due to the potential gain on conversion to shares
Conversions rights vary - specified dates, periods and number of conversions
Nuber of shares may differ between issues, or fixed or reducing
If not converted, the Bond will revert to a conventional bond on end, but a company retains the right to redeem any outstanding stock
What is a floating rate note?
Securities issued by companies that are linked to a money market rate, such as LIBOR
