AF4: Why should i invest in a fixed interest security? Flashcards
How is gilt income distrubuted and how are they taxed?
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Gilts: direct investment or collectives
- Usually paid out half yearly
- Income tax - paid gross but taxable
- CGT - Direct are CGT exempt; collectives are subject to CGT
How do you measure the returns from a fixed interest security such as a gilt?
You use a running yield (also known as a interest yield or flat yield). This shows the % return you will get from the security, based on the price you paid.
You can also use a redemption yield. If you are comparing returns with other types of investment (such as cash), this is a fairer way of comparing returns as it not only looks at the yield, but also the gain or loss when it matures.
In other words, it compares the overall return from the fixed interest security if it is held until security.
The clean price is the:
price you would pay for a fixed interest security (e.g. gilt or corporate bond) which excludes the accrued interest.
Interest is normally paid twice a year.
If you buy a gilt on the date the coupon is paid (or later), the price you pay will will include the market value of the gilt and the coupon (interest). This is known as the dirty price.
UK fixed interest securities are normally quoted on a dirty basis.
How do you calculate the running yield, i.e. what does the formula look like?
Coupon x 100
Current cost
How do you calculate a gross redemption yield, i.e. what does the formula look like?
(coupon / clean price) x 100
+ or -
(loss or gain to maturity (£) / number of years to maturity) x 100
Clean price
This shows the return if every coupon is reinvested plus the capital gain or loss at maturity.
What is meant by the duration of a bond and how can it be used?
It is the period of time (years) it will take to repay initial outlay, in terms of interest and capital
It is used to measure sensitivity of fixed interest investment to changes in interest rates
It is also known as The Macaulay Duration
What is meant by the modified duration of a bond and how can it be used?
This estimates how much a bond’s price will change if there is a change in interest rates.
The formula for calculating modified duration is:
Duration (or Macaulay Duration)
(1 + Gross Redemption Yield)
How do I estimate the change in price on a bond when I know the change in interest rates?
Estimated Price Change = MD x IR x Clean Price
MD = Modified Duration
IR = Change in Interest Rates e.g.1% = 0.01
What are the key features of permanent interest bearing shares (PIBS)?
- Issued by building societies
- A fixed interest security
- Income paid half yearly and gross
- CGT exempt
- No FSCS protection
- Income payments can be missed
- Missed payments do not have to be repaid in the future
