2. Main Asset Classes - Cash, Bonds, Equities & Property Flashcards

Question

B1. Characteristics (page 12)

Answer 1

Governments and companies often raise the long-term finance they need from the capital markets in the form of BONDS. This provides competition with other lenders (such as banks): - banks may not be able to lend for a long enough period - bond markets off a wider range of lenders - bonds are often the cheapest way of borrowing money HENCE why lots of large companies use the bond markets to raise money rather than taking out loans with their banks.

Answer 2

Bonds are known as: - Negotiable (can be sold to the secondary markets) - Fixed-interest (borrower/issuer committed to paying interest for the duration of the bonds term) - Long-term (issued for 5 - 30/50 years) - Debt instruments (bonds represent financial debt) However some bonds are variable, are index-linked and pay no interest at all.

Answer 3

UK Government Bonds: GILTS International Bonds: EUROBONDS Corporate Bonds: DEBENTURES, LOAN STOCK, LOAN NOTES Title of Bonds has three components: - ISSUERS NAME - COUPON - MATURITY DATE INTEREST: Most bonds pay the coupon twice yearly, regardless of interest rate changes. Interest is paid gross.

Answer 4

Bonds are traded by their nominal value, otherwise known as 'par' or 'face' value. Prices are quoted in the Financial Times but these are not what the investor would pay for two reasons: 1. These are mid-market prices. Buyers would actually pay a higher price (the offer price), and receive a lower price on sale (the bid price) on sale 2. They are clean prices, which means that they do not include any interest. To determine the full price of the bond the interest (which accrues daily) needs to be added to work out the 'dirty price'

Answer 5

Bonds are usually classified according to: - their issuer - their structure or characteristics - what market they are issued in

Answer 6

Goverment bonds are issued by governments to raise finance. They are issued in that country's own domestic currency. Are usually 'risk-free' but not always (Russia in 1998, Greece in 2000s).

Answer 7

Conventional gilts carry a: - Fixed Coupon (i.e. 2%) - Single repayment date (i.e. 2025) - Interest is paid every six months until maturity, at which point the holder receives the final interest payment and the return of capital - Usually issued with coupon dates of 7 March & September or 7 June and December Conventional gilts represent 70% of UK Government bonds in issue.

Answer 8

Index-linked gilts are where: - the interest payments and capital increase by inflation over the term of the bond - interest is paid every six months with capital returned at maturity, except these payment are adjusted to take account of inflation over the bond term - inflation adjustment in line with RPI - no deflation floor, so the redemption amount could be less than the face value The inflation uplift is calculated at different period before rdemption as follows: Issues prior to July 2005: Eight months before Issues after July 2005: Three months before

Answer 9

STRIPS: Seperate trading of registered interest and principle securities A stripped gilt is: - one that is seperated into it's indiviual coupon payments and redemption payment - each of these payments can then be seperately traded as a zero-coupon bond with a known redemption value - the entire return is in the form of a capital gain

Answer 10

Carry a fixed coupon but have two dates in which they can be repaid: 2% Treasury 2020-25 NOT CURRENTLY IN ISSUE

Answer 11

Carry a fixed coupon but have no remption date: 2% Treasury NOT CURRENTLY IN ISSUE

Answer 12

UK Government bonds are classed by the DMO according to their TIME LEFT to maturity: - SHORTS: 0-7 years left to run to redemption - MEDIUMS: 7-15 years left to run to redemption - LONGS: 15+ years left to run to redemption The Financial Times classifies shorts as 0-5 years Gilts with 50 year redemptions can be referred to as ultra-long

Answer 13

Corporate bonds are usually secured on a company's assets by either: - FIXED CHARGE: a legal charge (or mortgage) placed on one or a number of the company's fixed assets - FLOATING CHARGE: places a more general charge on assets which continually flow through the business such as the company's stock-in-trade

Answer 14

Some corporate bonds are issued with CALL provisions: - enables the issuer to buy back all or some of the issue before maturity - attractive to the issuer because the bond can be refinanced when interest rates are lower than that being paid on the bond - investor will probably demand a higher yield as compensation

Answer 15

Some corporate bonds are issued with PUT provisions: - give the bondholder the right to require the issuer to redeem early - makes the bond more attractive to bondholders - increases the risk of refinancing the bond at an unplanned time (bad for the issuer)

Answer 16

- standard corporate bond issues | - maturities ranging from 9 months to 5 years

Answer 17

- are conventional bonds that have fixed coupons - interest paid half-yearly or annually - have predetermined redemption dates

Answer 18

- have a variable rate of interest - the rate of interest is linked to a benchmark - was LIBOR but now SONIA

Answer 19

- carry the right to be converted into ordinary company shares - conversion can take place at predetermined points during the life of the bond - if the conversion rights are not used then it becomes a conventional bond that repays on a fixed date

Answer 20

- pay no interest - issued at a discount and redeemed at its par value - all of the return is capital growth

Answer 21

Permanent interest bearing securities (PIBS): - irredeemable - fixed interest - issued by building societies - pay 6 month coupons GROSS - PIBSs holders rank behind everyone in liquidation Perpetual subordinated bonds (PSBs): - this is a PIB where the building society has demutualised. The PIBS are reclassified as PSBs

Answer 22

Eurobonds are large international bond issues made by governments and suprantional organisations.

Answer 23

- issued by foreign borrowers/issuers | - denominated in the currency of that country

Answer 24

This is where bonds can be converted into ordinary shares of the issuing company. Buying at a premium is a more expensive way of obtaining the shares. Buying at a discount is a cheaper way.

Answer 25

The issuing and selling of ORIGINAL bonds takes place in the PRIMARY MARKET. Any trading thereafter takes place in the SECONDARY MARKET.

Answer 26

UK Government issues gilts via the DMO which does this weekly and uses an auction process: - large investors put in bids at the price and for the quantity of stock they want - successful bidders pay the price they bid - non-competitive bids can be made for amounts up to £500,000. If successful they pay an average of accepted prices

Answer 27

Other organisations or companies issue bonds less frequently. They appoint an investment bank to manage the issue: - the issue and prospective coupon are marketed to potential investors - indicative bids are placed at a certain price - final terms are agreed and issued to prospective investors, who have 24 hours to make firm bids

Answer 28

The trading of bonds after their original issue does not affect the original issuer or change the terms of the bond. There is substantial trading activity in four major markets in the UK: - the government sector - the corporate sector - sterling loans to foreign borrowers - the Eurobond market

Answer 29

Bonds are measured by the returns they provide as a percentage of the investment made: The YIELD

Answer 30

Interest yield is the return as investor gets on the purchase price of a bond. It is also known as the: - running yield - income yield - flat yield Calculation: Coupon Interest Yield = ------------------- x 100 Clean price

Answer 31

Redemption yields take into account any gain or loss that will be made if the bond is held until maturity. When a bond is held to maturity, only its nominal value is repaid. So if a bond is purchased for £127.86, yet the face value was £1,000, then a loss of £278.60 is made: £1,000 x £127.86 / 100 - £1,000 = £278.60 If the coupon is above current interest rates, the bond will trade above par (will result in capital loss), and if the coupon is below current interest rates, the bond's price will be below par.

Answer 32

Redemption yields take into account any gain or loss that will be made if the bond is held until maturity. Calculation: (par - mp) / years to redemption) Interest yield + ( ---------------------------------------------- x100) mp mp = market price Steps are detailed in the calculation flash cards as it involved the interest yield, market price and redemption yield.

Answer 33

One of the major relationships tracked by analysts is the redemption yields for bonds of varying maturities. This is normally presented as a Yield Curve.

Answer 34

In normal circumstances, investors demand higher yields over the longer term to cover the increased risks and uncertainties that the longer term to redemption brings. This is known as 'liquidity preference' - where investors need to be rewarded to tie up their capital. The yield curve is then a rising 'positive' curve.

Answer 35

A flat yield curve can come about where there is no perceived reinvestment risk. This comes about when investors do not expect interest rates to change in the future and do not demand a premium (or accept a discount) for investing long-term.

Answer 36

This is where the yield is the opposite shape to that of a normal yield curve. This is because the yield on longer-term bonds is less than that of shorter-term bonds. Caused by investors expecting interest rates to rise in the short term.

Answer 37

Equities usually outperform bonds, except for the last two decades where bonds have outperformed equities.

Answer 38

Main risks associated with bonds: - Credit Risk (interest / capital payments may not be made) - Market or Price Risk (movement in interest rates has significant affect on bond values) - Unanticipated Inflation Risk (it rising sharply) - Liquidity Risk - Exchange Rate Risk - Early Redemption Risk (issuer may invoke a call option) - Seniority Risk (ranked low in respect of issuer's liquidity)

Answer 39

When bonds are first issued they are assigned a credit rating by an agency - this will affect the initial pricing and yield of the bond. Investment Grade Bonds: have a rating (highest liquidity and quality) Non-Investment Grade (Junk Bonds): lowest ratings, speculative, less liquidity

Answer 40

Usual order of creditworthiness: 1. Governments 2. Supranationals (World Bank / European Bank) 3. Local government institutions 4. Large international companies and major banks 5. Smaller listed companies Worth credit ratings normally means a higher yield to compensate for the risk being taken.

Answer 41

When Interest Rate RISE: - Prices of outstanding bonds fall - to bring the yield of older bonds into line with the new higher interest rate When interest rate FALL: - Prices of outstanding bonds rise - until the yield of older bonds is low enough to match the lower interest rate

Answer 42

All bonds react differently to changing market conditions; this is known as VOLATILITY. - Longer the period to redemption - MORE volatile - lower the coupon - MORE volatile

Answer 43

Duration allows the sensitivity of one bond verses another to be compared: E (net present value of the bonds cash flow x time) -------------------------------------------------------------------------- E Net present value of the cash flows to be received

Answer 44

Modified Duration allows us to compare the sensitivity of a bond to changes in interest rates. - This estimates how much a bond's price will change if there is a change in interest rates Duration --------------------------------------- (1 + Gross Redemption Yield)

Answer 45

Can calculate what effect a % rise (say 1%) in yields will be on the bond's price. Our Duration of 2.74 means that the price should change by 2.74%. A bond priced at 97.28 would therefore fall (because the yield has risen) by: 97.28 - (97.28 x 0.0274) = 94.61

Answer 46

Over 2,000 companies (including 300 foreign ones) are listed on the London Stock Exchange (LSE)

Answer 47

A company is a legal entity formed to conduct business or other activities in the name of its members.

Answer 48

Two types of share can be created, ORDINARY and PREFERENCE.

Answer 49

- represent the risk capital of the company - last to be paid out in the event of liquidation - holders have a right to dividends - holder have a right to vote at company meetings A Shares: participate in profits and dividends but are non-voting B Shares: usually redeemable shares and issued as part of a capital return to investors Deferred Shares: often paid to founders and only pay a dividend after a period of time

Answer 50

- less risky than ordinary shares - company does not have to pay a dividend - but when it does, they are paid to preference holders before ordinary share holders - no voting rights - pay out first in the event of liquidation Preference Shares: carry a fixed dividend but if is not paid the right is lost Cumulative PS: if the dividend is not paid the right rolls over and arrears have to be paid before any ordinary dividends Participating PS: additional dividends may be payable if profits allow Redeemable PS: issued with a certain lifespan by which the company will buy them back at nominal value Convertible PS: can be converted to ordinary shares

Answer 51

Shareholder's rights fall into two categories: - Basic Rights - Statutory Rights

Answer 52

Primary market is where the shares are first listed on a stock market. Once issued, the trading afterwards takes place in the secondary market (such as the London Stock Exchange). Listing process is regulated by the UK Listing Authority (UKLA) which is part of the FCA. When a company obtains a stock market listing, this is now known as an Initial Public Offering (IPO) of which there are three main types: - Offers for sale - Placings - Introductions

Answer 53

Offer for sale is the most common form of issuing new shares. Fixed Price: - Can be offered when the compnay is large and stable - Shares offered at a pre-determined price - The issue is underwritten (banks agree for a fee to buy unsold shares) - Offer price set under the technical optimum to encourage overscription which puts upward pressure on the share after issue (growth)

Answer 54

Tender Price: - this involves getting bids from potential investors to try and gauge a sensible price and establish interest in a share before setting a 'strike' price - once bids are in a strike price is decided - shares are then sold to all those who have bid at or above the strike price

Answer 55

Offers for subscription: - is a special form of tender price - the issuer seeks bids above a minimum 'subscription level' - but does not commit to go through with the issue until a certain level of deman is met - commonly used for new investment trusts

Answer 56

Placings are the fastest and cheapest method of issuing new shares. Very popular for smaller companies. Process: - the issuing company decides on a suitable price for the shares - the company calls on directly on big institutions (pension funds, banks) and makes a presentation

Answer 57

This is where established companies want to list their shares on a stock market. No new shares are listed and no new money raised, the shares are just made available on a stock market. The shares can now be traded through the exchange rather than being sold privately.

Answer 58

In the 1980s and first half of the 1990s many issues were via PRIVATISATION and DEMUTUALISATION: Privatisation: Many UK Government assets were sold off to reduce Government debt Demutualisation: Mutual companies do not have shareholder or pay dividends. They are owned by their members and offer them preferntial rates. - demututalisation is where the mutual company becomes privatised to more easily raise capital for growth

Answer 59

Main secondary markets in the UK are: - London Stock Exchange (LSE) - NEX Exchange

Answer 60

BEST EXECUTION - when placing trades on behalf of a client, firms have to meet their duty of best execution (as per COBS) General regulatory obligations - first must take all reasonable steps to obtain the best possible result for the client Retail clients - a best possible result is determined in terms of 'total consideration' which takes account of price, execution costs and any expenses Professional clients - total consideration is the benchamark for standards Execution venues - firms must trade at a venue which can obtain the best result for the client. Under FCA rules a firms is now required to: - have an 'execution policy' which covers the venue being used and what factors used when carrying out the trade(s) - inform clients about the execution policy - assess the execution venues annually - monitor the effectiveness of the execution arrangements - if requested, show the client that their order has ben executed in line with the execution policy

Answer 61

Once listed, a company may choose to be involved in a takeover or merger. These are coporate actions and there are over 150 different types.

Answer 62

When companies come back to the stock market to raise additional capital, three main methods are used: 1. Placings (smaller capital raising events) 2. Open offer (existing shareholders offered the chance to subcribe to new shares on a pro-rata basis at a discount) 3. Rights issues - offered to existing sharholders first to ensure no dilution - used to fund specific expansion plans - strengthen the balance sheet - refinance the company after a crisis - rights issue expressed as '1-for-3' or '2-for-5' - discounts of 20% - 50% are common

Answer 63

Rights issues lead to changes in the share price. The price to which the original shares will fall is know as the theoretical ex-rights price. Once the rights issue has been announced investors have four options: 1. Take up 2. Sell the rights in the market 3. Sell sufficent to take up the balance (sell some of the rights to generate cash to pay to take up the remainder) 4. Lapse Rights Premium is the difference between the new share price and the ex-rights price.

Answer 64

Sometimes shares are issued for other reasons than raising capital: 1. Bonus issues 2. Share splits

Answer 65

This is where further shares are issued to existing shareholders without raising further funds. COMPANY HAS RETAINED PROFITS. It helps reduce the price per share without reducing the market holding of the investor. Brings the company's share capital more in line with its real worth. Reduces the share price to make it more marketable.

Answer 66

This allows an existing share to be split. For example, a £1 ordinary share is split into two 50p ordinary shares. COMPANY DOES NOT TRANSFER REVENUE FROM RESERVES, UNLIKE BONUS ISSUES / BONUS SHARES.

Answer 67

Companies restructure their share capital as a way of returning excess capital to shareholders.

Answer 68

Returns from equity holdings come from dividens and capital growth. Either Historic or Prospective date may be used when calculating measures of share value: - Historic date comes from actual past returns - Prospective data comes from projective results

Answer 69

Shareholders are ENTITLED to a share of company profits in the form of dividends, however they do not have a RIGHT to a dividend. Whether one is payable is decided by the board of directors.

Answer 70

The other key component of returns from equities is that of Capital Growth.

Answer 71

To understand risk and return we must examine long periods of past performance.

Answer 72

Risks associated with investing in equities: - Price Risk: share prices may fall (loss of capital value) - Liquidity Risk: shares may be difficult to sell at reasonable prices depending on when they need to be sold - Issuer Risk: the risk that the issuing company collapses and the shares becomes worthless

Answer 73

It is one of the main assets held my private individuals.

Answer 74

- property is an asset-backed investment - can provide long-term protection against inflation - in locations where businesses flourish, more people live so demand for property rises as do rents - commercial property values follow business profitiability - tenants of commercial have to pay a rent even when they make a loss, unless the property becomes vacant and a tenant cannot be found (property becomes a drain) Commercial property sectors: offices, retail, indusutrial

Answer 75

Returns on an investment in property are meansured by an INITIAL YIELD (which is a %) as follows: Annual rental income Initial Yield = ----------------------------------- x 100 price of the property Returns on property can be judged by looking at an appropriate index, such as the Investment property Databank (IPD).

Answer 76

Main risk is LACK OF LIQUIDITY: - property is relatively expensive to buy and sell - can take time to sell (and to buy) - not possible to sell in segments - cannot use the annual CGT examption

Answer 77

CASH ASSETS - quoted rates for cash deposits may not reflect the true rate (need to consider tax, charges etc) - cover provided by the FSCS should not stop an investor from checking the creditworthiness of an institution - money market is for professional investors but can be accessed by mutual funds INDEX LINKED BONDS - these provide protection against inflation - amount of capital returned depends on inflation 3 - 8 months before redemption - no protection against deflation BONDS - bonds are measured by the returns they provide as a % of the investment made (the yield) - Interest Yield and Redemption Yield are the most important measures - bonds may trade above or below par - the lower the bond's credit rating the higher the yield EQUITIES - to be listed on a stock exchange a company must be authorised by the UKLA - bonus issues and share splits can reduce the initial price of a share to make it more marketable PROPERTY - property can add diversification to a portfolio but it is not readily realisable - the high level of expenses can impact on the yield