2. PRINCIPLE ASSET CLASSES Flashcards
Benefits/risks
of cash deposits
BENE
- security - FSCS protection up to 85k
- accessibility - usually immediate unless term deposit
- liquidity - instant access to deposits 2nd only in liquidity to cash
RISKSAS
- interest rates may not keep up with inflation
-inflation eroding value
- portfolio cash accounts - not protected by FSCS
types of cash acc - instant access, notice account, term deposit and money market acc
6 Characteristics of money
DIVIDIBILITY - can be split into smaller denominations
DURABILITY - durable, easily replaceable
TRANSPORTABILITY - easy to carry
LIMITED SUPPLY - supply must be controllable (by the gov)
ACCEPTABILITY - must be widely accepted in exchange for goods. Declaration of legal tender by govs makes the currency acceptable to baso anyone
UNIFORMITY - uniform - all £5 notes worth the same amount
Simple Mac and Mod Dur calc
Blockchain
cryptocurrencies use blockchain tech = system of recording information that makes it difficult/impossible to change = digital leger of transactions duplicated and distro across entire network
Crypto
- issues with using crypto as money
Digital currency designed to work on blockchain tech as a medium of exchange
- anonymous nature of transactions (illegal/immoral activities)
- potential for gov to ban/regulate their use
- periodic failure of some currencies
- multiplicity of currrency makes it hard to understand pros and cons of each
- not FSCS protected whereas cash is
- ease with which new cryptos can be set up
Crypto regs
largely unregulated
Feb 23 - UK gov published plan for regulatory framework tgar it will apply to crypoassets
regulators in diff countries have conflicting views on crypto - may create regulatory loopholes
in UK - crypto assets cannot be promoted to retail clients
Tax treatment of crypto
gains typically subject to CGT even tho crypto is digital and therefore intangible
losses allowable to offset against gains tho may have to provide proof it is arises as result of destruction of private encryption key
what does FSCS cover
compensate customers of fin. services firms in case of insolvency
covers deposits, credit unions, insurance pols, pensions, insurance brokering, endowments, investments, mortgages, debt management
key provision is to protect cash deposits up to 85k per person per authorized instit
- originally under EU directive 100k eur rebal every 5 years
doesnt cover deposits outside of EEA
temp large balances protected for 6 months up to 1mn (e.g. proceeds from house sale, insurance payout, inheritance etc)
Risks and adv of offshore banking
RISKS
Security - main risk. may be little or no compensation offered for deposit loss.
deposit - sometimes large min deposit - could be at risk in war/coup/currency devaluation
access -usually straightforward btut could be as issue in dev countries where transactions are slower
compliance standards - offshore banks that comply with high standards must take extra steps to ensure this so often charge higher fees. lax banks spose their own issues - attract high risk customers, scrutiny from regs, can result in bank failure
professional advice - often needed when setting up offshore acc due to complicated tax structures
may attract criminals - can be opened without full declaration of beneficial ownership (money laundering/tax evasion)
ADV
security - some countries bank deposits may not be secure - so offshore banking may actually offer a more secure alternative
service - often very personalised with relationship managers
convenience and access - worldwide access for individuals whose home gov imposes capital controls
tax - tax advantages will depend on investors domicile. IHT planning (legal or otherwise)
investing - may offer access to different investment funds
FX - may be cheaper
flexible lending and credit
fees, interest and charges - may offer higher rates due to lower overheads and reduced govi control. interest almost always gross
economic protection - for investors facing deterioration at home
FSCS global alts
FDIC - deposits in US insit up to $250k (SVB more)
PBOC - 500k yuan per depositor
SARB - 100k rand per depositor per bank
deposit acc types
instant access - cash immediately accessible (can be limits on withdrawals e.g. x amount/day)
notice accounts - depositor must give notice of intent to withdraw or suffer interest penalty - higher interest than instant access due to less liquidity
term deposit - cash deposited over predefined period for enhances rate. early withdrawal prob not permitted or allowed with big penalty
- often provided as fixed rate bond by bank
money market accounts
- certain banks offer money market deposits for deined periods, rates and currencies - IR reflects the current MM rates
- call account allows invest to access money on working day and by a specific time (close to instant access and offers rat aligned to base rate)
tax treatment of cash deposits
- gross interest (from April 2017)
- first 1k (500 higher) tax free
- no CGT
what is an ISA]
types?
- tax efficient wrapper for residents
- no income tax or CGT
types
-cash
-stocks and shares
-LISA
-flexible ISA
-innovative finance ISA
JISA
H2B ISA
risks and advantages of offshore banking
RISKS
Security - main risk. may be little or no compensation offered for deposit loss.
deposit - sometimes large min deposit - could be at risk in war/coup/currency devaluation
access -usually straightforward btut could be as issue in dev countries where transactions are slower
compliance standards - offshore banks that comply with high standards must take extra steps to ensure this so often charge higher fees. lax banks spose their own issues - attract high risk customers, scrutiny from regs, can result in bank failure
professional advice - often needed when setting up offshore acc due to complicated tax structures
may attract criminals - can be opened without full declaration of beneficial ownership (money laundering/tax evasion)
ADV
security - some countries bank deposits may not be secure - so offshore banking may actually offer a more secure alternative
service - often very personalised with relationship managers
convenience and access - worldwide access for individuals whose home gov imposes capital controls
tax - tax advantages will depend on investors domicile. IHT planning (legal or otherwise)
investing - may offer access to different investment funds
FX - may be cheaper
flexible lending and credit
fees, interest and charges - may offer higher rates due to lower overheads and reduced govi control. interest almost always gross
economic protection - for investors facing deterioration at home
money markets
financial instit and dealers inc ash/credit who borrow/lend for ST usually up to 12 months
no centralised XC, decentralised similar to FX market
benchmarking to LIBOR
ST instruments commonly commercial paper, REPOs or similar
convention is to issue in bearer form
highly liquid
often no coupon - discounted secs which redeem @ par
money market participants
central bank - to conduct monetary policy not to paise finance + lender of last resort if systemic risk
commercial banks
maintain liquidity for capital adequacy requirements
companies
short term flexible finance, hedge IR rate exposure
instits (pensions funds, fund managers) -
maintain portion of fund in cash, MM allow generation of return
intermediaries - arbitrage ops between buyer and seller. most important in MM are IDB
short dated bonds
technically <5 yrs but definition can vary
sovereign risk in MM is country specific
usually ST govis
also FRNs - linked to ST MM rates
ZCBs - issued @ discount and redeemed at par
commercial paper
issued by corp - equivalent to short dated IG gov bond
typically zero coup and issued @ discount
no security
life of around 3 months
issued by large comps to assist in liqudiity management - placed w/ instit investors
(minimum denomination is 100k)
asset backed CP, 90-180 days, issue dby banks or financial instit with and notes backed by physical assets
finance comps use receivables from loans provided to customers as collateral for raising money in C market
Treasury bills
ST loan instruments guaranteed by gov
maturity <1 yr @ issue
1, 3, 6 month maturities in UK
no coupon - issued @ discount (tho can have negative yields and be issued at prem)
issued by DMO in UK
can be held in CREST and Euroclear
issued @ weekly auctions (tenders) - competitive 500k min NV bid, multiples of 50k
subsequent trading min denomination is 25k
tenders are on fri - eligible bidders are large financial instits including all major banks
not risk free because of inflation risk
T bill yield
yield % = (100-price)/(price x days/360)
days = days to maturity
Annualization and decompounding
Annualise: 4.8% annual interest paid quarterly
Decompound: 25% return over 7 yrs
A = (1+r)^n -1
A = (1.012)^4 -1 = 0.0489
0.25 = (1+r)^7 -1
1.25 = (1+r)^7
1.25^1/7 -1 = r
Bond characteristics
Risks associated with bonds
INTEREST RATE - rates expected to rise, price falls so yield rises to reflect increased rates. heavily impacted by inflation expectations
CREDIT RISK - risk of issuer defaulting on payment of coup or principle. ratings agencies help tho they are not super trustworthy
INFLATION - risk inflation will undermine returns through decreased purchasing power
LIQUIDITY - ease with which issue can trade effects its risk and therefore the yield required
ISSUE SPECIFIC - eg embedded options, callable bonds etc
FISCAL - risk witholding taxes will be increased
Macauly duration
= Economic life of the bond
How long it years it takes for the price of the bond to be repaid by its cash flows
= weighted average term to maturity of the cash flows from a bond
= elasticity of a bond’s price in relation to interest rates
= higher duration = more sensitive to rates (as well as lower coupon and yield and longer time to maturity - all more sensitive to rates)
Determinants of mac duration
Coupon - higher = lower duration
Time to maturity - higher = higher duration
Yield - higher = lower duration
How to calculate Macauly duration
Value each CF using YTM as discount rate
x each value by the period and sum
MD = Sum of PV x period /price
Modified duration
= - Mac duration / (1+ yield)
Gives approx for how much bond’s price will move for 1% change in yield
-ve value since price has inverse relationship with rates
only an approximation due to convexity because mod duration implies linear price yield relationship
IRR
Uses and limitations
R1 = lower rate
R2 = higher rate
N1 = NPV with R1
N2 = NPV with R2
Calc N1 and N2
N2 should be neg
Use interpolation formula
IRR = discount rate that makes NPV of future cash flows = 0
is annual growth rate investment is expected to generate
-useful for comparing projects - choose one with higher IRR
- should choose investment with higher NPV @relevant cost of capital
- negative cFs result in multiple IRRs
- assumes all CFs invested @ IRR rate
Meaning of cost of capital
= min return necessary to justify undertaking project
Convexity
actual relationship isnt linear - increases in yields results in prices dropping at reducing rate - but relationship is actually convex
mod dur - will overstate fall in price and understate rise
longer maturity = higher convexity
lower coupon = higher convexity
lower yield = higher convexity
if same mod duration - higher coup = greater convexity
Convexity = (Total convexity calculation / bond price) / coupon frequency²
Formula for convexity adjustment = 0.5 x Convexity x Yield change² x Bond Price
Gordon’s growth model
Values shares based on NPV of future dividends
Purchasers of a share are discounting the expected future growth in
earnings and dividends
PROBLEM - what is comp doesnt pay out divi because it is reinvesting profits into future growth?
- investors will tolerate this more with younger, higher growth comps than with mature
For pref shares: P/r (r and g are in decimals)
Bene and drawbacks of discount model
BENE
- simple and easy to understand and apply
- focuses on most visible form of returns to SH (divi)
- relies on only a few parameters
DRAWBACKS
- doesnt deal well when req rate of return is lower than divi growth
- canr value firms who dont pay divi
- narrow range of parameters, may not capture firm value
Complicated Gordon’s growth
£1 divi last year
Grows @ 10% for 3 years
Then 4% constant after that
9% req rate of return
Value each CF like a bond
Last CF = Grow divi by perp growth rate for numerator
Denominator = (r-g) x 1.09^3 as in 3y time
Influences on share price movements
*Earnings prospects and asset value of company
*Board membership
*Adverse factors affecting company - e.g. legal action, loans being called in etc.
*Industry or economic surveys
*tips in financial media
*research ratings (upgrades/downgrades)
*Macro economic developments e.g. interest rate expectations, inflation reports etc (some more than others, e..g house builders)
*Changes in government policy e.g. fiscal and monetary policy
*Movements in global markets
*Geo-political developments including wars, terrorism etc.
*takeover/merger rumours
*deviations from traditional divi patterns
*earnings reports (missing/beating expectation, anticipation of earnings)
Equities in a multi asset portfolio
Expected to provide long term growth
Can provide hedge against inflation since comp revs should rise with inflation and thus so should share price
equity risk premium is high
No guaranteed returns
Diversification - within sector, between sectors and geogs helps reduce unsystematic risk
Want combo of shares with low correlation to eachother (in short term, over LT shares prices will be broadly correlated)
Equity vol
Considered riskier than FI counterparts
CBOE VIX index - measures short term 30 day market vol of S&P option prices
VIX itself is volatile
discourages investment in periods when market concerns are rife (COVID, GFC)
if you remain invested and can withstand vol - equities can produce substantial risk adjusted returns
Perf of equities
Have provided best real returns of all main asset classes over LT
10.1% pa S&P500 since 1928
Price/earnings multiples (divi val)
Ord vs pref shares
Ord shares = most common type, represent permanent capital for a company. risk capital - last to be paid if comp goes into liquidation (typically nothing left
Preference shares: stock with divi paid to shareholders before common stock dividends are paid out
VOTING RIGHTS
ord - voting rights
pref - usually no voting rights (typically exception if havent received divi in 5 + years)
DIVI
ord - variable (discretionary, only paid out of profits and distributable reserves after prev divi)
pref - fixed
pref shares preferred because
- divi is paid in full before ord divi
- on wind up - higher repayment priority than ord
pref :( because
= divi fixed so wont benefit from sig increase in profit but more downside divi protection than ord
Types of ord shares
Ord shares = most common type, represent permanent capital for a company. risk capital - last to be paid if comp goes into liquidation (typically nothing left
Preference shares: stock with divi paid to shareholders before common stock dividends are paid out
Ord shares carry voting rights
Variable, discretionary divi paid after pref shares
Lower priority than pref shares in repayment
‘A’ SHARES
- non voting ord shares - issued often by family companies to avoid loss of control
- likely trade at discount to voting shares
GOLDEN SHARES
- special voting rights, can outvote other shareholders in certain circumstances
often introduced by founders - ‘founder shares’
often used by comps that the government privatized, held by gov giving effective control
used in brazil to maintain control of state run companies
DEFERRED
- not entitled to divi payment until certain condition met
e.g.
- time elapsed since issue
- profits exceeding certain level
-other classes paid x level of divi
REDEEMABLE
- can issue so long as comp has at least one other share class
-may be bought back by the comp either at option of comp or holder on specified date
Types of pref shares
Pref shares pay fixed rate of divi which is paid before ord shares
Repaid on wind up before ord shareholders
No security attached
Usually no voting rights (exception if no divi for 5 years)
CUMULATIVE - most pref shares = this
- if divi not paid due to insufficient profits - next divi cant be paid to ord shareholders until any pref arrears have been made up - divi rights baso carried forwards
NON CUMULATIVE
- divi rights not carried forward -arrears dont have to be made up
PARTICIPATING
- right to receive additional divi when profits exceed certain level - participate in good performance
- additional amount usually expressed as % of ord divi
REDEEMABLE
- will be bought back by company at agreed price on agreed date (in title)
CONVERTIBLE
- option to convert to ord shares
Limited comps
public limited companies(plc) - limited liability of the shareholders
insolvency - shareholders not liable to pay off debt
For private comps - often loans provided require personal guarantee against owners so they do incur liability for company
ROE
ROE = net income/book val of SH equity - pref shares
gauge of profitability and how efficiently profits are generated
Yield curve and equity value vs growth
RISING RATES - value outerperforms
Bear flattening = ST rates rise faster than LT
Bear steepening = LT rates rise faster than ST rates
FALLING RATES - growth and high divi outperform
Bull flattening = LT rates fall faster than ST
Bull steepening= ST rates fall faster than LT rates
PE ratio
P / E ratio (x) =Current share price / Earnings per share
valuation based on profitability prospects
Looks at how many x share price exceeds level of profits per fshare - indicator as to level on confidence market has
Historic = using actual last 12m EPS or last financial year EPS
forwards - EOY forecasted figure
P /B ratio
P /B ratio (x)= Current share price / Book value
Alternative to PE - used often where company is loss making or asset heavy
Not great where comp has more intangible assets (copyrights, goodwill, patents) or if comp has large amounts of debt which negate value of tangible assets
BV = (assets - intangible - value of all liabilities) / number of ord shares in issue
P/B <1 = market valuing comp at less than the value of its assets
- may indicate share undervalued or that assets assumed to be overvalued or some other factor depressing share price
High P/B = investors willing to pay more as they think comp will generate sufficient profits from assets/that investor considers assets to be undervalued
Price to sales (P/S)
P/S ratio (x) =Market capitalisation / Total sales or revenue over the past 12 months
- shows how much the market values every pound/dollar of sales
- if comp doesnt earn profit yet - investors can use P/S to determine if stock is over/under valued vs peers
Divi yield
Dividend yield (%) = Dividend per share / Share price
- not directly comparable between companies as divi payout ratio is v individual
- growth stocks tend to have low or zero divi yields as profits reinvested but low yield doesnt defo mean company will grow
- high yield could signal company is insecure - so must pay high divi to compensate or could be comp just has v strong CFs
Divi cover
Dividend cover (x) = Earnings per share / Dividend per share
Looks @ ability to maintain current level of divi
2x or higher generally considered prudent
unusually high implies most of profits are reinvested for future growth
<1.5x may suggest not sustainable
<1 - divi funded in part using retained earnings and divi is uncovered which is likely to be concerning to investors
BENE AND LIMITS OF ACTIVE MANAGEMENT
BENE
- can tailor strat to meet specific goals
- allows specialist investment strats
- have potential to generate better performance relative to benchmark index over time post fees
- investors have flexibility to choose assets that they believe will outperform
- many active managers are supported by big team of analysts = extensive research to find investment ops
DRAWBACKS
- better performance not guaranteed, can lag benchmarks
- many fail to beat benchmark consistently over long periods tho there are exceptions
- can be hard work and time consuming
- fees can be high which has compounding effect over time, an have exit and perf fees
- top managers can be selective as to who they take on and may have high initial min thresholds
- some actively managed funds are closet trackers
BENE AND LIMITATIONS OF PASSIVE
BENE
- lower fees (reduced marketing, distro, accounting, investment costs)
- liquid
- v transparant, clear which holdings are in portfolio
- frequently rebalanced, so investing in passives requires minimal trading
- wide variety of indices avail to suir broad range of styles
-common ETF structure means they are more tax efficient than mutual funds
LIMITATIOS
- when adjusting portfolios to reflect constituent changes, may end up over paying when buying and selling @ depressed prices
- cash drag and internal costs can effect perf and cause tracking error
- can be overly concentrated
- buy and sell decisions based on index not on research
Core satellite approach
Designed to minimise cost, vol and tax while allowing for outperformance
Incorp trad secs in passively managed funds (Core) to be held LT (70-80%)
minimises risk of outperformance
Balance held in a number of specialist actively managed funds/individually selected secs (satellite) comprising holdings that investor expects will outperform market
Core can be run on enhanced index basis where techniques included to add value (stock lending, anticipating index entry/exit)
Also can have semi active index
Smart beta
emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way
SMart bets = fund objective is to overcome main drawback of passive funds (automatically following market down and inability to avoid troublesome holdings)
Smart Beta investing follows an index but also considers alternative factors in choosing the stocks from the index
e.g. equal weighted, factor based, low vol
combinebenefits of passive and active
Hard and soft commodities
a raw material or primary agricultural product that can be bought and sold = relatively homogenous allowing standardized contracts
HARD
- metals and energy =most common
- natural resource that must be mined/extracted
- finite resources
-mental prices influenced by supply and demand, precious metals benefit from flight to safety, act as store of value
- Copper, lithium and cobalt key for net zero transition (Cu wind turbines and Li/Cu for batteries)
- demand for oil generally driven by consumption tho OPEC have recently controlling supply to support price
-
SOFT
-agricultural prods or livestock
- naturally renewable on annual cycle
- many are perishable both before and after harvest which can make prices volatile
- effected by harvest qual, disease, weather, climate events
Direct commodity investment
CASH MARKET (physical purchase)
- expensive to store and insure
-large min quantities
-risk of deterioration (especially for softs)
-standard contract size with gradings to specify quality
-gives fungibility to wholesale market
-more for whole/industry than investors
FUTURES MARKET
- contract to buy/sell set quant of asset on fixed future date @ price agreed today
- delivery is deferred
- no need to take delivery
-standardised parcels (contracts) e.g. 25 tonnes of copper
- must trade in whole numbers of contract (limitation that favours OTC swaps)
-homogenous specified asset
FORWARDS/SWAPS
- forward = private customisable, OTC
-commodity swap (floating commodity price vs fixed) = used to hedge against swings in market and lock in price
AVD/DISADV
- returns historically diversifying vs trad asset classes
- tend to be inputs to manufacturing process so can be a hedge against inflation as prices should rise alongside
-prices tend to be extremely volatile as driven by supp/demand
- heavily influenced by macro favours
- storage costs can be v high with physicals
Indirect commodity Invesment
Shares of commodity comps
- e.g. miners/oil producers, revenues and therefore share price linked to commodity price
-correlation not perfect as there are many other factors + hedging costs
Commodity funds
- hedge against inflation, more cap growth focused>income
-retail UCITS cant invest in commodities, but nonretail and QIS can (UCITS can use derivs to invest in commodity index)
- commodity ETF = provide exposure to commodities/basket by buying UL commodities/futures/shares in comps
-ETCs typically track a single commodity, share price moves with spot/futures price of UL
ADV/DISADV
- not closely correlated with trad asset classes
- ETCs and ETFs are v liwuid
- some funds pay divi unlike physical commodity investment
- low storage costs
- more reasonable minimum dealing size
- Physically backed ETCs only give exposure to one commodity or small handful
- Funds may buy shares of comps which are influenced by other factors
advantages and disadv of property investment
ADV
- historically attractive absolute returns
-diversification (low corr to trad investments)
DISADV
- liquidity
- lumpy returns
-transaction and maintenance costs
-effect of gearing
-correlation with economic prosperity
- risk of void periods
Types of direct investment in property
COMMERCIAL
- retail = shopping centres, shops, supermarkets etc - usually lowest yielding
- offices - highly correlated with economy, tenant usually responsible for repairs, long term contacts, most return via rental income. expensive so limited to comps/instits
- industrial - estates and distro warehouses etc, long term lease and higher cost of refit so likely lower rental income
agricultural - wide variation of tenancy lengths, expensive, rental income and land appreciation
RESIDENTIAL - typically short, renewable leases, landlord resp for repairs, rental income and price appreciation
Rental yield
Gross rent should be adjusted to include void periods
Expenses includes agents costs, insurance, renewals of furnishings (not mortgage interest tho)
Purchase cost includes agents charges, surveys, initial cost of furnishings
Rental yield will depend on demand, property quality, terms
Also affected by vacant periods, previous tenants
bond covenants
baso just conditions that protect holders
covenants limiting further debt and priority -
negative pledge clause
- prevent issuer from reducing val of bond by issuing additional debt @ higher priority or
pari passu clause
- only allowing debt to be issued at higher priority is existing bonds are upgraded to have equal priority
covenants restricting divi payment
- excessive divis could negatively impact bond value - covenants frequently restrict payment of cash divi based on earnings and cash
- can also restrict buyback facility
covenants restricting sale of assets
- to prevent val falling due to asset sale - often assets only permitted for sale if proceeds used to buy new fixed assets or retire debt
- can prohibit transfer of whol bis or require new owner to assume all obligations of bond
breach of covenants is a default event - if no solution is found afer engagment period post default - bond becomes immediately repayable
green bonds?
GBP?
conventional debt where proceeds used to finance/refinance new/existing green projects
- w/ positive environmental or climate benefits e.g. energy efficiency, transportation
additional transaction costs - issuer must track, monitor and report on funds
- issuers think this is offset by benefits (diversifying investor base, highlighting greenness etc)
lack of standardization as to what makes a green bond - can lead to greenwashing, green label can confer pricing advantage
GBP - green bonds principal dev by ICMA - completely voluntary recommendation of guidelines + transparency and disclosure, promoting integrity etc
fall from green grace - bonds losing green status -reputational and price damage - could put cap at risk due to downward pressure.
canlead to ‘green default’ - investors seeking penalties for breaking green clauses even if bond is paid in full
social bonds
bond with proceeds used to fund projects with non environmental but beneficial theme - typically with social objectives in mind
e.g. basic infrastructure, affordable housing, health services - particularly to benefit those livign below poverty line
first ever - Asia 2018 - to provide stable LT housing in Korea
like green bonds - ICMA has issues SBP (social bond principles) - voluntary guidelines where issuers may align framework to market expectations = market confidence
sustainability bonds
funds used to finance or refinance combo of green and social project - ICMA has issued SBG - sustainability bond guidelines - promoting integrity etc, voluntary
sustainability linked bonds (SLBs)
any bond instrument where financial and structural characteristics vary depending on whether issuer has achieved ESG/sustainability objectives
more flexi than green/social/sustainability bonds which can only be used to finance specific projects
- no specific use of proceeds - but issuer must define/commit to sustainability path over years
ICMA has vol SLBP guidelines = sets out best practise for launching credible slb
SLBs are complimentary financing to green/social/sustainability bonds
blue bonds
proceeds used for protection and conservation of marine ecosystems
generally issued by low-income countries that are heavily reliant on oceans and their resources
first sovereign blue bond: 2018 Republic of Seychelles - $15mn to support expansion of marine protected areas, fisherie governance
coupons partically guaranteed by world bank and concessional loan from GEF
social impact bonds
main goal is to achieve social objectives not investmentreturns
very diff from conventional bonds - focus is on social benefit > investment potential
payouts based on specific social criterias being met
dont offer fixed return
used by govt to address issues e.g. homelessness, youth unemployment, children in care etc
BASO
contract with GOV/pub sector issue, whereby it pays for better social outcomes + passes on part of the savings achieved to investors.
factors affecting bond price
rates (up P down) - investors need higher ROR as rates rise
inflation (up price down) - investors need higher ROR as inflation rises, for ILB price tends to rise as higher inflation expected - both prevailing and expected rates impact
liquidity - more liquid = more expensive
exchange rates
issuer specific factors
- credit rating - higher = higher price - lower yield
- structure and seniority of bond - higher = higher price
bond derivs
convertible bonds
gives holder right not obligation to conert bond into predetermined no. of ordinary shares of issuer @ fixed price @ set time @predetermined conversion ratio e.g. (25 shares per 100 NV)
holders only exercise if share price more attractive than prevailing market price
exposes holder to growth potential in rquity while retaining safety of bonds - trade at prem to shares they can convert into
characteristics of convertibles
until converted or maturity - react to changes in yield and IR like other bonds
employed as deferred shares - issuers expect conversion @ conversion date/period
predefined conversion ratio - e.g 25 per 100 NV (maybe with price per convert too)
conversion right may only be on maturity or may exist for period of time
lower coup than straight corp
subordinated debt instruments
poss additions
- put rights - to force early redemption normally at premium to par
- call rights - under certain conditions @ certain price
adv and disadv of convertibles to issuer
Advantages
- lower coupon issuance
- no immediate dilution of shareholder control
- no assets required to secure straight finance
- good for finance projects with LT payback
- less EPS dilution than normal share/bond issue
- interest payments tax deductable unlike equity finance
Disadvantages
- coupon payments required even if comp makes no profit unlike divi payments
- if poor performance - would have to redeem for cash if holder chooses not to convert
- cannot be sure firm is issuing deferred share cap as may not convert
- future dilution of shareholders
advantages and disadvantages to investor of convertibles
advantages
- security of fixed income with downside protection if shares fall with option to participate in uplift from + share price performance
- higher coupon vs divi yield (lower than straight corp)
- very liquid vs straight corp
- above shares in liquidation
disadv
- unsecured, lower ranking debt - lower repayment piroiry
-often callable
-dilution of existing shareholding on conversion
-if cshares go down - yield sacrified vs corp with no benefit
- lower yield than corp (higher than corresponding eq)
conversion ratio
no. of shares the bond can be converted into
e.g. x shares per £100 NV
ratio = NV/conversion price
conversion price
convertible price/no. of shares
can use NV if converting at maturity
conversion value
current share price x conversion ratio
conversion ratio = NV/conversion price
conversion premium
conversion price - share price /share price
yield curve theories
liquidity pref theory
- longer term commitment = higher compensation required - explains upward sloping curve
- people desire liquidity so must be compensated more if they are lending for longer(3 motives)
- spot rates are the egg - forward rtaes and yields derived from them
pure expectations theory
- shape varies according to rate expectations
-steep upwards = expecting rate rising, increased demand for ST bonds
-downward = rates expected to fall, want to lock current rates in now
-flat curve - no expected change in rates
- argues that curve is reflection of spot rates which are reflection of forward rates (yield = weighted avg of spot rates which are geometric mean of forward rates)
- yield curve reflection of spot rates and spot rates reflection of forward rates (egg)
preferred habitat/segmentation - different investors in different segments of maturity spectrum
- pensions/insurance companies at long end
- banks in short end
- 2 nds of curve have life of their own since they react differently to same data
interest rate risk BONDS
= potential that a change rates will reduce the value of a bond
prob most important risk factor - due to relationship between rates and bond prices
can be mitigated by matching macaulay duration with liability
or with FRNs or step up bonds to mitigate effect of rate changes or ILBs
inflation risk BONDS
risk that inflation will undermine the performance of an investment
linked to IR risk as rates will rise to compensate bondholders for decline in purchasing power
may be reduced with ILBs
credit/default risk BONDS
risk of issuer defaulting on obligations to pay coupons and repay principal
ratings help to assess this risk - though reputational damage caused during financial crisis due to ratings of MBS
mitigated by investing in highly rated bonds
liquidity/marketability risk BONDS
loss incurred when a market participant wants to execute a trade or to liquidate a position immediately while not hitting the best price - i.e. ease with which asset can be sold for best price
- worse for smaller issues and off the run stocks (not most recent issue)
currency risk BONDS
exposure to losses/gains in the value of currency when converting CFs
can be mitigated by buying bonds in investors home currency
fiscal risk
risk that witholding tax will increase
or risk of capital controls locking money into market with foreign bonds
issue specific risk
risk arising due to specific bond issue e.g. call rights
