3.) Raising Capital Through Debt Instruments - Gilt Edged Securities Flashcards
Define why companies need to raise capital
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
Define why governments need to raise capital
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
Define the ways in which capital is usually categorised, and what each category involves, respectively
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
Define the different types of debt, and who can issue them
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)
Define the difference in terms of maturities between bills and bonds, two of the different types of debt
Bills - maturities of less than 1 year
Define gilts
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
Define the acronym PSNCR
Public Sector Net Cash Requirement
Define the Public Sector Net Cash Requirement (PSNCR)
The difference between the revenues raised and expenses occurred in running the country’s finances
Describe why the UK Government issues gilts
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
Define who needs capital and why
Companies and governments need cash to operate
Briefly describe how gilts are normally classified
According to how many years they have to run until they are redeemed, I.e. the capital is repaid by the Government to investors
Briefly describe how the Financial Times (FT) classifies gilts
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’
Briefly describe how the London Stock Exchange classifies gilts
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’
Compare how the Financial Times (FT) and the London Stock Exchange (LSE) classify gilts
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’
Describe the four basic features of government gilt
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
Define the acronym DMO
Debt Management Office
Define and describe marketable securities, a key feature of gilts
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
Define and describe the ‘Current Price’ basic feature of Government gilts
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
Define and briefly describe the Redemption Date basic feature of Government Gilts
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
Define and briefly describe the ‘Name’ basic feature of Government Gilts
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
Define and briefly describe the ‘Coupon’ basic feature of Government Gilts
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
Define the term yield, when applied to investments
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
Define the various types of yields
Interest Yield (also flat or running yield)
Yield to Redemption - Gross Redemption Yield
Net Redemption Yield
Grossed Up Net Redemption Yield
Define and briefly describe the type of yield known as Interest Yield (also flat or running yield)
The interest yield expresses the income received by the investor in gilts as a percentage of the capital outlay.
Define and briefly describe the type of yield known as Yield to Redemption - Gross redemption yield
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
Describe how the annualised capital gain or loss on a Yield to Redemption - Gross redemption yield can be calculated
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
Describe the formula used to calculate Interest Yield
Divide the coupon rate by the market price and multiply by 100 (coupon rate divided by market price x 100 = %)
Define and describe how one would obtain a Net Redemption Yield
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.
Define the acronym GUNRY
Grossed Up Net Redemption Yield
Define the yield Grossed Up Net Redemption Yield (GUNRY)
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.
Define the formula used to calculate Grossed Up Net Redemption Yield (GUNRY)
Net redemption yield X 100
DIVIDED BY
(100-marginal rate of tax)
Define and briefly describe how payment of interest on gilts is made
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
Define and briefly describe the acronym xd, in terms of accrued investment adjustments
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
Define and briefly describe cum div, in terms of accrued investment adjustments
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
Define the accrued interest scheme
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)
Define and describe how accrued interest investments are made
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
Define the adjustments made for an individual buying and selling gilts ‘cum div’, as part of the accrued income scheme
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
Define the adjustments made for an individual buying and selling gilts ‘ex div’, as part of the accrued income scheme
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
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
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
Define the key advantages of gilts as an investment
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
Define the key disadvantages of gilts as an investment
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
Define the four outlets for private investors to obtain gilts
Direct offer
Auction
Via a stockbroker
Via the Post Office (using the Bank of England’s Brokerage Service)
Define how private investors can obtain gilts via Direct Offer
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
Define the acronym DMO
Debt Management Office
Define how private investors can obtain gilts at auction
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.
Define how private investors can obtain gilts via a stockbroker
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
Define how private investors can obtain gilts through the Post Office (using the Bank of England’s Brokerage Service)
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.
In terms of gilts, what is the UK Government’s DMO (Debt Management Office) 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.
Define the acronym GEMMs
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.
Define the acronym SEMBs
Stock Exchange Money Brokers
Define SEMBs (Stock Exchange Money Brokers)
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)
Define the acronym IDBs
Inter-Dealer Brokers
Define IDBs (Inter-Dealer Brokers)
IDBs enable the GEMMs to deal between themselves more readily and speedily.
Define how most trading in gilts is now settled
Via CREST (Certificate-less Registry for Electronic Share Transfer)
Define the acronym CREST
Certificate-less Registry for Electronic Share Transfer
Define CREST (Certificate-less Registry for Electronic Share Transfer)
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.
Define and describe the participants in the Gilt-Edged Security Market
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.
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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)
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IDBs enable the GEMMs to deal between themselves more readily and speedily.
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Most trading in gilts is now settled through CREST (Certificate-less Registry for Electronic Share Transfer)
