3. Fixed-interest investments

Question 1

What is a fixed-interest investment?

Give 5 examples of fixed-interet invsetments

3.1 Introduction

Answer 1

An investment where the interest rates and income element is fixed

Examples:
* Gilts
* Local authority bond
* Corporate bonds
* Permanent interest-bearing shares (PIBS)
* Eurbonds

Question 2

What is a bond?

3.1 Introduction

Answer 2

A form of investment that can be thought of as a loan. In return for a cash deposit, the investor receives:
* Interest payments
* Repaymend of deposit at maturity

Terms typically exceed 5 years.

Question 3

What is a Gilt?

Who are they issued by?

3.2 Gilt‑edged securities (gilts)

Answer 3

A gilt is a government bond issued by the DMO (debt management office). They are seen as very safe as the governement is extremely unlikely to default on repayment.

Question 4

Key terms for Gilts - Par value, coupon, redemption date

3.2 Gilt‑edged securities (gilts)

Answer 4

Par value - The value that will be repaid at the end of the term.

Coupon - The fixed interest rate. Interest is paid half-yearly and is based on the par value and not the current price

Redemption date - The maturity date; the date whereby the government will pay the par value back to the investor.

Question 5

Name and descirbe two forms of Gilt

3.2.1 Forms of gilt

Answer 5

• Fixed‑interest (conventional gilts) – where the interest rate paid remains the same until redemption and the par value remains the same.

Index‑linked– where both the interest and the redemption value are linked to inflation.

Question 6

Gilt catergories - based on term length

Name the 4 catergories. What is a convertible gilt?

3.2.2 Gilt categories

Answer 6

Short-dated (Shorts) - Less than 7 years to run (Financial press - less than 5 years to run.

Medium-dated (Mediums) - Between 7-15 years to run (Financial press -5-15 years to run

Long-dated (Longs) - Longer than 15 years

Ultra-long gilts - 50 and 55 year terms

A convertible gilt are shorts with the option to covert to a longer-dated gilt

Question 7

What are the benefits or attractions of investing in Gilts?

3.2.3 The benefits

Answer 7

• Guaranteed income for a specified period
• Ability to be traded on the stock exhange - trading gilts in excess of their face value; heavily dependant on prevailing interest rates and inflation at the time.

Question 8

Return from gilts is expressed in terms of yield - What is the Running yield

How is it calculated? What is the net interest yield?

3.2.4 Yields

Answer 8

Represents the investors real return on their money.

Calculated by:
(Coupon ÷ market price) x 100

The net interest yield is the initial yield adjusted to allow for income tax.

Question 9

Return from gilts is expressed in terms of yield - What is the Redemption yield

How is it calculated?

3.2.4 Yields

Answer 9

Takes into account any capital appreciation or loss against the par value and the income (coupon) due to be paid up until redemption date.

Method for caluclating:
1. Calculate the total income received over the term. X
2. Deduct or add any gain/loss from X. This is Y
3. Divide this (Y) by the number of years of term. Z
4. Use Z as the coupon for the regular running yield calculation =

(Z ÷ market price) x 100 = Redemption yield

Question 10

What is the relationship between gild yields and interest rates?

3.2.4 Yields

Answer 10

Interest rates higher than the coupon = Gilt price falls.

Question 11

Selling Gilts - Ex-dividend?

3.2.4.3 Gilt prices

Answer 11

Means ‘without dividend’
Gilts go ex-dividend seven working days (the cut‑off date) beforethe regular interest payment is due.

The seller receives the next dividend payment.

Question 12

Selling Gilts - cum-dividend?

3.2.4.3 Gilt prices

Answer 12

Means ‘with dividend’
The gilt has been sold before the cut off date, meaning that the next interest payment will go to the buyer.

Question 13

Gilt yield curve meanings? Normal, Flat curve, Reverse (inverted curve)

Describe and what they mean

3.2.5 Yield curves

Answer 13

Normal - Yield increasing over time. pessimism over inflation and interest rates = steeper the curve
Flat - No major changes to inflation/interest. Face and par value of gilt similar
Reverse - When interest rates are expected to fall in the future, investors often move from short‑
to long‑dated gilts in an attempt to lock into higher rates. The inverted curve can also be caused by demand for long‑term gilts outstripping supply, causing prices to rise

Question 14

Taxation of Gilts

3.2.6 Tax treatment of gilts

Answer 14

• Gains from gilts are exempt from capital gains tax.
• Interest is paid gross and is taxable as savings income.

Question 15

Risks of Gilts

3.2.7 Volatility and risk

Answer 15

• Gilts present a very low risk investment - Government backed, guaranteed coupon and par value
• Less volatile that shares (equities)
• Gilt values are vulnerable to rises in inflation – they tend to drop if inflation rates are
  expected to rise
• Gilts generally outperform equities in the short term.

Question 16

Uses of gilts

Answer 16

• Provide a guaranteed income for a specified time
• Very high yielding gilt - converting capital into income but is purchasing a defined income stream.

Question 17

Corporate Bonds - What are they?

How do they compare to Gilts?

Answer 17

Corporate bonds are issued by businesses looking to raise capital over the long term - Investors pay a loan to the business to fund projects.
* Terms of 5-30 years
* Only companies with good credit ratings can issue bonds (AAA-D)
* Tend to be more risky thank gilts
* Yields tend to be higher than gilts in recognition of the increased risk.
* Corporate bond prices are more volatile than gilts.
* Corporate bond market is not as liquid as the gilt market

Question 18

Types of bond - 8 types

Describe - pg 177

3.3.1 Types of corporate bond

Answer 18

• Debentures
• Loan stock
• Convertible loan stock
• Deep-discount bonds
• Zero-coupon bonds
• Speculative (junk) bonds
• Convertible bonds
• Contingent convertible bonds

Question 19

What is a qualifying corporate bond?

5 points

3.3.2 Taxation of corporate bonds

Answer 19

• Denoted in sterling and has no rights to convert or redeem it into any other currency
• Does not carry a right to conversion into certain shares or other securities – this
  means convertible loan stock does not qualify;
• Does not give the holder rights to subscribe for additional shares or securities;
• Offers an interest rate that does not exceed a reasonable commercial rate, and cannot
  depend on the issuing business’s results;
• Redeemable at par or on terms that are comparable with other listed securities.

Question 20

Taxation of Corporate bonds?

3.3.2.1 Income tax + 3.3.2.2 CGT

Answer 20

Income Tax
Interest on qualifying corporate bonds is paid gross, and interest is eligible for the
starting‑rate band where applicable, and the investor’s personal savings allowance (PSA).
* Any gain made on sale or redemption will be subject to income tax in the year of disposal
* Deep discounted bonds taxed differently

CGT
* Qualifiying Corp Bonds are exempt - except for Convertible loan stock
* Corporate bond unit trusts and OEICs are subject to CGT on encashment

Question 21

What is a Eurobond?

pg 179

Answer 21

Eurobonds are long‑term, interest‑bearing securities (bonds). They are issued by a
government or a company in a currency that is different from that of the place of issue.

Key point:
* Interest payable can be fixed or floating.
* The issuer can choose a currency appropriate for its needs.
* Interest is payable semi‑annually or annually, depending on the bond.

Question 22

Permanent interest‑bearing shares (PIBS)

pg 179

Answer 22

• Issued by building societies
• Similar to corp bonds
• Fixed interest on a half-annual basis
• Paid gross and taxable as savings income
• No redemption date - do not have to be repaid
• No CGT on gains made.

The Financial Services Compensation Scheme does not cover PIBS in the same way as
other building society investments,

Question 23

Perpetual subordinated bonds?

Answer 23

When a building society converts to a bank, PIBS to Perpetual subordinated bonds

Question 24

How are gilts and bonds issued?

Three ways they are issued. When bonds are traded…

3.6 Dealing in fixed‑interest securities and products

Answer 24

• Direct issue – the issuer sells directly to the buyer at a set price. This method is used for small issues and bonds remaining after an auction.
• Auction – the bonds are offered at auction, with investors putting in a bid for the amount they want and the price they will pay.
• Tender – those wishing to buy put in a tender (offer) at, or above, the stated minimum price.

When bonds are traded, they are are sold to investors at the offer price and bought back at the bid price

Once issued, bonds can be trade in the stock markets

Question 25

Benefits of fixed-interest investments

3.7.1 Risk profile

Answer 25

• A return of capital at the end of a specified period;
• A specified rate of return for a specified period.
• FI investments that do not provide an income offer potential for capital growth

Question 26

Risks involved with fixed-interest investments

3.7.1 Risk profile

Answer 26

Generally low-risk due to their return of capital and specified rate of return.
* Return of capital is a promise, not a guarantee
* Risk that the return may not match or exceed the rate of inflation

Question 27

Tax efficiency of Fixed-interest securities

How are they taxed?

3.7.3 Tax efficiency

Answer 27

Corporate Bonds pay income that is taxed as savings income and eligible for the Savings allowance and Starting-rate band where possible.

Gilts and bonds can also give rise to capital gains, which are entirely free of tax.