Basics of fixed interest Flashcards
What are fixed interest securities and their characteristics?
Fixed interest securities are a mechanism by which large companies, institutions and governments raise capital. They are generally considered ‘long-term’ (in this case we mean they typically run for 2-30 years).
They promise to pay a rate of return in exchange for having access to the investor’s capital. They are effectively loans from the investor.
All fixed interest securities, bonds, will generally share certain characteristics:
► They will have a fixed redemption value, known as the par value – this being the amount that will be repaid by the borrower
► They are repaid after the set period has elapsed
► They carry a set rate of interest known as the coupon
Why do bonds have an inverse relationship with interest rates?
There needs to be an incentive for someone to invest in a bond, this incentive is quite often the yield the bond is offering when compared to other investments of the same risk. i.e, they need to offer the same yield
of comparable investments of the same risk,
otherwise an investor would choose the one that offers the highest yield.
Given the fact the income paid (the coupon) is “fixed” the only way the yield can change (the return you get for the price you paid) is if the capital value (price) of the bond changes. Therefore, the yield the investor
requires (when compared to other investments) will set the price of the bond at any given time.
What are the main risks associated with bonds?
The main risks associated with bonds are discussed below, however they can be categorised into the following;
Commercial/Specific risks for that individual issuer and Market/Systematic risks for the fixed interest asset class as a whole.
What is liquidity risk when looking at bonds?
► Some bonds will also be relatively hard to sell on the open market. The risk that the investor might not be able to find a buyer is known as the liquidity risk of the bond.
How can default risk effect bonds?
There is the chance that the issuer of the bond will not be able to pay back the interest or the capital due. This is the
default risk. This risk of default will vary according to the strength of the bond issuer. If you consider the government
for example, relative to a company. Both may issue bonds but the chances of the government defaulting are very small
compared to a proprietary company – though with the last global economic crisis, in some cases the gap has considerably narrowed! In any case, the risk associated to the individual bond is known as a specific or commercial risk. It is specific to the bond issuer.
Whateffect does market risk affect have on bonds?
These are risks that will have an impact
on all bonds, not just one. For example, the inverse relationship between interest rates and bond prices described above is a market risk. If interest rates rise, the
likely impact is a fall in all bond prices.
How does inflation affect bonds price and yields?
Where the market expects inflation to rise, the likely effect is a fall in bond prices. Again, this is intuitively reasonable. If the
market expects the value of a fixed coupon to be reduced by high inflation, it will be willing to pay less for that coupon and
the price will fall.
How can economic factors affect bonds prices?
Economic factors such as monetary or fiscal policy can affect bond prices as these policies can affect interest rates e.g. growth in the economy can cause inflation and
as a result interest rates may rise to combat this, which then reduce bond prices.
What is more volatile, a bond with a low coupon and a longer term to redemption or a bond with a higher coupon and shorter term to redemption?
The volatility of bonds is important to consider, in general terms bonds with lower coupons are more volatile as are bonds with longer redemption periods (maturity dates).
This is because the coupon payments are exposed to movements in interest rates for a longer period of time.
Simply put if you have two bonds with similar redemption periods but different coupons, the bond paying the higher
coupon bond will provide a return more quickly than the bond with the lower coupon as most of that return is paid
out on maturity.
For two bonds with a similar coupon but different redemption periods, the holder of the shorter dated bond will receive a return on the bond earlier than the holder of
the longer dated bond (when considering the redemption payment on maturity) and as such will only be subject to interest rate movements for a shorter period of time.
what is the timeframe of a short dated GILT
less than 7 years according to the government Debt Management Office (DMO) or less than 5 years according to the financial press
what is the timeframe of a medium dated GILT
between 7 and 15 years (DMO) or 5 and 15
(press)
what is the timeframe of a long dated GILT
over 15 years
what is the timeframe of a undated GILT
no specific redemption date
What is the difference between conventional gilts and index linked gilts?
These work in the same way as a standard gilt with one main difference, instead of the coupon and redemption amount being “fixed”, they fluctuate in line with inflation
(linked to inflation) measured by RPI.
If the gilt is issued before Sept 2005, then the value of RPI is taken 8 months prior to each payment date.
If the gilt is issued after Sept 2005, then it is taken 3 months prior to each payment date.
What are the risks of index linked gilts?
Linking payments to inflation can obviously
create a way to protect your income/investment from the damaging affects of inflation and as such these “valuable” benefits usually mean that the coupon and yields on index linked bonds are lower than those of conventional ones.
There is also a potential downside too, its all well and good getting inflation proofing returns but you have to also be prepared to have returns (interest and capital payments)
reduced if RPI falls
