3.) Raising Capital Through Debt Instruments - Gilt Edged Securities

Question 1

Define why companies need to raise capital

Answer 1

Funds expansion plans

Invest in research and development

Purchase new plant and machinery

However, their cash income, e.g. from sales, doesn’t always cover their cash expenditure. Therefore, companies (and governments too) must seek alternative ways to raise additional capital to fund their shortfall

Question 2

Define why governments need to raise capital

Answer 2

Invest in new hospitals/schools

Maintain UK infrastructure, I.e. roads/networks

Fund defence activity, I.e. war

However, their cash income, e.g. from taxes, doesn’t always cover their cash expenditure. Therefore, governments (and companies too) must seek alternative ways to raise additional capital to fund their shortfall

Question 3

Define the ways in which capital is usually categorised, and what each category involves, respectively

Answer 3

Capital is usually categorised between debt and equity

Debt = borrowing money with a commitment to repayments capital and interest at an agreed date in the future

Equity = issuing shares in return for cash from investors

Furthermore, companies have the option to raise capital through either debt or equity instruments. Governments don’t have such a choice as they cannot raise equity. Governments can only raise debt finance

Question 4

Define the different types of debt, and who can issue them

Answer 4

Debt - companies and government

Debt securities - companies and governments

Equity - companies only

Bank loan - companies only

Bills - maturities of less than 1 year

(Note that Capital is split between debt and equity)

Question 5

Define the difference in terms of maturities between bills and bonds, two of the different types of debt

Answer 5

Bills - maturities of less than 1 year

Question 6

Define gilts

Answer 6

A gilt is a bond issued by the UK Government.

A bond reflects a promise by the issuer to pay interest at the stated rate in order to repay capital, if applicable.

Investors who purchase bonds are making loans to the issuer of the bond

Question 7

Define the acronym PSNCR

Answer 7

Public Sector Net Cash Requirement

Question 8

Define the Public Sector Net Cash Requirement (PSNCR)

Answer 8

The difference between the revenues raised and expenses occurred in running the country’s finances

Question 9

Describe why the UK Government issues gilts

Answer 9

The U.K. Government issues gilts in order to help fund the Public Sector Net Cash Requirement (PSNCR), the difference between the revenues raised and expenses occurred in running the country’s finances.

Investors who buy gilts are therefore loaning money to the Government, who in return pays a rate of interest that can be fixed, variable, or index-linked, depending on the terms of issue of the loan stock.

The loans are repayable by the Government, either on a set future date, or between future dates, although there exist gilts, which under the terms of issue, impose no obligation at all on the Government to repay the capital sums outstanding

Question 10

Define who needs capital and why

Answer 10

Companies and governments need cash to operate

Question 11

Briefly describe how gilts are normally classified

Answer 11

According to how many years they have to run until they are redeemed, I.e. the capital is repaid by the Government to investors

Question 12

Briefly describe how the Financial Times (FT) classifies gilts

Answer 12

Shorts - up to 5 years

Mediums - 5 to 15 years

Longs - over 15 years

Undated/irredeemable - no obligation to redeem

Note that it is the REMAINING maturity of the gilt that’s used for categorisation purposes. E.g. A 20-year gilt starts as a ‘long’ when initially issued, but five years later it becomes a ‘medium’, and ten years later it becomes a ‘short’

Question 13

Briefly describe how the London Stock Exchange classifies gilts

Answer 13

Shorts - up to 7 years

Mediums - 8 to 15 years

Longs - less than 15 years

Undated/irredeemable - no obligation to redeem

Note that it is the REMAINING maturity of the gilt that’s used for categorisation purposes. E.g. A 20-year gilt starts as a ‘long’ when initially issued, but five years later it becomes a ‘medium’, and ten years later it becomes a ‘short’

Question 14

Compare how the Financial Times (FT) and the London Stock Exchange (LSE) classify gilts

Answer 14

Shorts - up to 5 years (FT) / up to 7 years (LSE)

Mediums - 5 to 15 years (FT) / 8-15 years (LSE)

Longs - up to 15 years (FT) / less than 15 years (LSE)

Undated/irredeemable - no obligation to redeem (Same for both)

Note that it is the REMAINING maturity of the gilt that’s used for categorisation purposes. E.g. A 20-year gilt starts as a ‘long’ when initially issued, but five years later it becomes a ‘medium’, and ten years later it becomes a ‘short’

Question 15

Describe the four basic features of government gilt

Answer 15

For example:

Coupon - expressed as an annual percentage of the nominal value, and is the rate applicable to the coupon, I.e. 6.5%, indicating the amount of interest per annum (p.a) that an investor will receive on the nominal value of the gilt, e.g. For every £100 held, £6.50 will be received in interest. The interest is paid twice a year, on set dates chosen by the Government

Name - the name given at issue, I.e. Treasury Stock. The Debt Management Office (DMO) deals with all internal procedures regarding the issue of gilts on the Government’s behalf

Redemption Date - the year in which the Government will repay the nominal sum held by the investor, I.e. 2010. In effect, it is the Government repaying its loan

Current Price - always expressed as an amount per £100 nominal of the gilt, i.e. £109.75. This nominal or par value is the amount which is actually purchased by an investor and which will be repaid by the Government when it redeems the gilt on the due date

The current price pf the featured gilt is £109.75 for every nominal £100. For every £1 nominal of the gilt will cost to purchase £1.0975. So an investor who wants to buy £30,000 nominal of the gilt will have to pay, ignoring brokers costs and accrued interest:

£30,000 x £1.0975 = £32,925

Question 16

Define the acronym DMO

Answer 16

Debt Management Office

Question 17

Define and describe marketable securities, a key feature of gilts

Answer 17

Marketable Securities are another key feature of gilts. They means that investors who hold gilts don’t need to wait until the redemption date before receiving their capital back but can sell all or part of their holding in the market.

However, when selling a gilt-edged security, investors must take the price that’s ruling the market at the time of selling, which may be more or less than what was originally paid for the gilt

Question 18

Define and describe the ‘Current Price’ basic feature of Government gilts

Answer 18

Always expressed as an amount per £100 nominal of the gilt, i.e. £109.75 (calculated via the £100 being at 6.5% for 18 months). This nominal or par value is the amount which is actually purchased by an investor and which will be repaid by the Government when it redeems the gilt on the due date

The current price of the featured gilt is £109.75 for every nominal £100. For every £1 nominal of the gilt will cost to purchase £1.0975. So an investor who wants to buy £30,000 nominal of the gilt will have to pay, ignoring brokers costs and accrued interest:

£30,000 x £1.0975 = £32,925

Question 19

Define and briefly describe the Redemption Date basic feature of Government Gilts

Answer 19

The year in which the Government will repay the nominal sum held by the investor, I.e. 2010. In effect, it is the Government repaying its loan

Question 20

Define and briefly describe the ‘Name’ basic feature of Government Gilts

Answer 20

The name given at issue, I.e. Treasury Stock. The Debt Management Office (DMO) deals with all internal procedures regarding the issue of gilts on the Government’s behalf

Question 21

Define and briefly describe the ‘Coupon’ basic feature of Government Gilts

Answer 21

Expressed as an annual percentage of the nominal value, and is the rate applicable to the coupon, I.e. 6.5%, indicating the amount of interest per annum (p.a) that an investor will receive on the nominal value of the gilt, e.g. For every £100 held, £6.50 will be received in interest. The interest is paid twice a year, on set dates chosen by the Government

Question 22

Define the term yield, when applied to investments

Answer 22

Yield, when applied to investments, generally refers to the return, which the investor is seeking to achieve as a result of making the investment. This return can by way of income received or gain in the value of capital, or both.

Yields are normally expressed as a percentage per annum of the capital invested and are quote gross or net of tax

Question 23

Define the various types of yields

Answer 23

Interest Yield (also flat or running yield)

Yield to Redemption - Gross Redemption Yield

Net Redemption Yield

Grossed Up Net Redemption Yield

Question 24

Define and briefly describe the type of yield known as Interest Yield (also flat or running yield)

Answer 24

The interest yield expresses the income received by the investor in gilts as a percentage of the capital outlay.

Question 25

Define and briefly describe the type of yield known as Yield to Redemption - Gross redemption yield

Answer 25

This yield takes into account that the investor may hold onto the gilt until the Government at a future date redeems it. Upon redemption of the gilt, the investor will either make a capital gain or suffer a capital loss depending on whether the gilt was bought at above or below its par value. Remember that on maturity, the Government will redeem the par value of the Gilt to the investor

An approximate gross redemption yield can be ascertained by adjusting the interest yield by the annualised capital gain acquired or capital loss suffered to the redemption date

Question 26

Describe how the annualised capital gain or loss on a Yield to Redemption - Gross redemption yield can be calculated

Answer 26

Step 1: 100 - market price, divided by number of years to maturity

Step 2: if market price of the gilt is below its par value of 100, then the capital gain per year will be added to the interest yield

OR: If the market price of the gilt is above its par value of 100, then the capital loss per year will be deducted from the interest yield

Question 27

Describe the formula used to calculate Interest Yield

Answer 27

Divide the coupon rate by the market price and multiply by 100 (coupon rate divided by market price x 100 = %)

Question 28

Define and describe how one would obtain a Net Redemption Yield

Answer 28

To obtain a Net Redemption yield, the investors rate of income tax must be taken into account.

The interest yield is reduced by the amount of the applicable rate of tax payable by the investor I.e. 0% non-taxpayer, 22% basic rate taxpayers and 40% higher rate taxpayers.

The net interest yield is adjusted to reflect the change in the capital element of the gilt in the same way as described above.

Question 29

Define the acronym GUNRY

Answer 29

Grossed Up Net Redemption Yield

Question 30

Define the yield Grossed Up Net Redemption Yield (GUNRY)

Answer 30

Used to compare the return on gilts (which don’t include any CGT) with a product (equities) that will have both income and capital gains tax payable on it. It takes the net redemption yield and grosses it up at the investors marginal rate of tax.

The resultant figure shows the return the equity investment would have to give to equal the return on the gilt.

Question 31

Define the formula used to calculate Grossed Up Net Redemption Yield (GUNRY)

Answer 31

Net redemption yield X 100

DIVIDED BY

(100-marginal rate of tax)

Question 32

Define and briefly describe how payment of interest on gilts is made

Answer 32

Every 6 months, with the exception of a few gilts which pay interest quarterly

The amount of interest received is determined by the coupon rate of the gilt and the nominal rate of the gilt held by the investor

Question 33

Define and briefly describe the acronym xd, in terms of accrued investment adjustments

Answer 33

xd = Without dividend

xd is what the price of a gilt is quoted as, 7 days before interest is due to be paid. Interest will be paid to all holders of the gilt as at this date.

Once a gilt has been issued, holders of the gilt receive interest for the full six months as at the xd (without dividend) date

Question 34

Define and briefly describe cum div, in terms of accrued investment adjustments

Answer 34

Cum div=with dividend

Cum div is what the price of a gilt reverts to, once the date of payment of interest on the gilt has been reached

Once a gilt has been issued, holders of the gilt receive interest for the full six months as at the xd (without dividend) date

Question 35

Define the accrued interest scheme

Answer 35

A scheme operated in order for an investor in gilts to receive interest for the exact number of days that the stock is held. The consideration (nominal amount X price) is adjusted to reflect whether the transaction is carried out on a cum div (WITH dividend) or xd (WITHOUT dividend)

Question 36

Define and describe how accrued interest investments are made

Answer 36

7 working days before interest is due to be paid, the price of the gilt is quoted as xd (WITHOUT dividend). Interest will be paid to all holders of the gilt as at this date. Once the interest payment date has been reached, the price will revert to being quoted as cum div (WITH dividend). Once the gilt has been issued, holders of the gilt receive interest for the full 6 months as at the xd date.

In order for an investor in gilts may receive interest for the exact number of days that the stock is held, a scheme operates known as the accrued income scheme. The consideration (nominal amount X price) is adjusted to reflect whether the transaction is carried out on a cum div or xd basis

Question 37

Define the adjustments made for an individual buying and selling gilts ‘cum div’, as part of the accrued income scheme

Answer 37

Cum div

Buying - interest from the last payment date to settlement date is added to cost

Selling - interest from last payment date to settlement date is added to sale proceeds

Question 38

Define the adjustments made for an individual buying and selling gilts ‘ex div’, as part of the accrued income scheme

Answer 38

Ex div

Buying - interest from the settlement date to the next payment date is deducted from cost

Selling - interest from settlement date to next payment date is deducted from sale proceeds

Question 39

Define and compare the adjustments made for an individual buying and selling gilts ‘ex div’ and ‘ex div’ as part of the accrued income scheme

Answer 39

Cum div

Buying - interest from the last payment date to settlement date is added to cost

Selling - interest from last payment date to settlement date is added to sale proceeds

Ex div

Buying - interest from the settlement date to the next payment date is deducted from cost

Selling - interest from settlement date to next payment date is deducted from sale proceeds

Note the contrasts between ex div and cum div, and between buying and selling each

cum div=added/last payment to settlement

ex div=subtracted/settlement to last payment

Buy=cost

Sell=sale proceeds

Question 40

Define the key advantages of gilts as an investment

Answer 40

For a personal investor, a portfolio with a gilt content will ensure an element of stability, as well as income

Advantages:

Capital is guaranteed to be returned if held to redemption

When gilt is redeemed, the investor receives his full nominal share back

A fixed rate gilt provides a known, fixed income

Free from CGT

Interest is paid gross unless UK residents wish to receive the income with tax deducted at source

Possibility of capital gain, if sell above par before redemption

Available to non-UK residents

Question 41

Define the key disadvantages of gilts as an investment

Answer 41

Fixed income may be eroded by inflation

Possibility of capital loss, if sell below par before redemption

Market prices may be volatile due to market forces, I.e. Supply and demand, interest rates, inflation rates, etc

Costs of buying and selling gilts if arranged through a stockbroker

No possibility of capital gain if held to redemption

Question 42

Define the four outlets for private investors to obtain gilts

Answer 42

Direct offer

Auction

Via a stockbroker

Via the Post Office (using the Bank of England’s Brokerage Service)

Question 43

Define how private investors can obtain gilts via Direct Offer

Answer 43

The Debt Management Office (DMO) makes a proportion of a gilt issue available to potential investors. Advertisements are placed in the financial press inviting applications at the fixed price quoted, or at a minimum tender price. Application forms can also be obtained from the DMO and the Bank of England’s Registrar’s Department.

If a gilt is under-subscribed, the DMO may take up the remaining amount not issued and sell the issue at a later time, according to suitable market conditions being present. This is referred to as an issue by way of a tap stock

Question 44

Define the acronym DMO

Answer 44

Debt Management Office

Question 45

Define how private investors can obtain gilts at auction

Answer 45

Private investors at a gilt auction can make (non-competitive) bids for a minimum of £1,000 up to a maximum of £500,000 and the likelihood that the bids will be met in full, although the Bank of England reserves the right to reject them. The bid price will be an average of the prices paid by the competitive bidders, I.e. Institutional investors. These bidders will only receive stock if they bid the highest price if the auction is oversubscribed

The investor won’t know exactly how much will be eventually paid, but it will represent the market price for the day in question. This also avoids the issue of dealing fees and the bid/offer spread that which applies when gilts are bought in the market.

Question 46

Define how private investors can obtain gilts via a stockbroker

Answer 46

Private investors should be aware that they will incur commission charges, and these will vary from broker to broker. In return for the fee, the investor may seek advice from the stockbroker as to which gilt may be more suitable

Question 47

Define how private investors can obtain gilts through the Post Office (using the Bank of England’s Brokerage Service)

Answer 47

This service offers the private investors the opportunity to buy and sell gilts by post. Application forms are available from post offices, or by telephoning the Bank of England Brokerage Service.

The completed forms, with payment, are sent to the Bank of England’s Registrar’s Department. The transaction will be auctioned when the application form has been received, so the Bank of England is unable to undertake to buy or sell stock at a particular price on a particular day.

Question 48

In terms of gilts, what is the UK Government’s DMO (Debt Management Office) responsible for

Answer 48

The new issue of gilts to the market

Note that the administration, I.e. Payment, is handled by the Bank of England

The DMO will deal with a large number of primary market makers known as GEMMs (Gilt-Edged Market Makers) who are obliged to maintain continuous two-way prices in gilts. GEMMs will deal with stockbrokers and also directly with large institutional investors.

Question 49

Define the acronym GEMMs

Answer 49

GEMMs (Gilt-Edged Market Makers) are obliged to maintain continuous two-way prices in gilts. GEMMs will deal with stockbrokers and also directly with large institutional investors.

Question 50

Define the acronym SEMBs

Answer 50

Stock Exchange Money Brokers

Question 51

Define SEMBs (Stock Exchange Money Brokers)

Answer 51

The activities of the SEMBs enhance the liquidity of the gilt-edged market, who lend cash and stock to the GEMMs and the IDBs (Inter-Dealer Brokers)

Question 52

Define the acronym IDBs

Answer 52

Inter-Dealer Brokers

Question 53

Define IDBs (Inter-Dealer Brokers)

Answer 53

IDBs enable the GEMMs to deal between themselves more readily and speedily.

Question 54

Define how most trading in gilts is now settled

Answer 54

Via CREST (Certificate-less Registry for Electronic Share Transfer)

Question 55

Define the acronym CREST

Answer 55

Certificate-less Registry for Electronic Share Transfer

Question 56

Define CREST (Certificate-less Registry for Electronic Share Transfer)

Answer 56

A UK-based central securities depository that holds UK equities and UK gilts, as well as Irish equities and other international securities.

CREST allows shareholders and bondholders to hold assets in a dematerialised, i.e. electronic form, rather than holding physical share certificates. CREST also serves a number of other important functions, such as assisting in the payments of dividends to shareholders.

Question 57

Define and describe the participants in the Gilt-Edged Security Market

Answer 57

The UK Government’s DMO (Debt Management Office) is responsible for the new issue of gilts to the market. (Note that the administration, I.e. Payment, is handled by the Bank of England)

The DMO will deal with a large number of primary market makers known as GEMMs (Gilt-Edged Market Makers) who are obliged to maintain continuous two-way prices in gilts.

GEMMs will deal with stockbrokers and also directly with large institutional investors.
V
The activities of the SEMBs enhance the liquidity of the gilt-edged market, who lend cash and stock to the GEMMs and the IDBs (Inter-Dealer Brokers)
V
IDBs enable the GEMMs to deal between themselves more readily and speedily.
V
Most trading in gilts is now settled through CREST (Certificate-less Registry for Electronic Share Transfer)