Cash and Fixed Interest Securities Flashcards
Risks of cash
- Default risk - creditworthiness of deposit taking institution
- Inflation risk - erodes purchasing power
- Interest rate risk - rates fluctuate
- Re-investment risk - risk that the rates available for maturing money are lower
- Negative interest rates have been seen with gilts and MM instruments and could spread to deposits, as seen in other countries
- Exchange rate risk for foreign currencies and offshore accounts - caution required regarding collapsing currencies / compensation schemes
Types of cash / fixed interest account
Instant access
Restricted access
Structured deposits - pay interest based on performance of equity index (e.g., FTSE 100), return is greater of original investment OR % change in index
Foreign currency
Offshore accounts
Cash ISA
NS&I products
Tax-free
- Direct ISA / Junior ISA
- Premium bonds
Income
- Income bonds
- Green savings bond
Savings Account
- Investment account
- Direct saver
Types of money market investments
Treasury bills
- Issued by government to finance daily cash flow
- 1, 3 and 6 month maturities
- No interest - issued below par and repaid at par on maturity
- Government backed and highly liquid
Certificates of Deposit
- Receipts from banks for deposits placed with them
- Fixed rates of interest and fixed term (can trade prior to maturity)
- Interest paid at maturity
- Interest rate depends on market rates / bank’s credit rating
Commercial Bills
- Short-term negotiable debt instruments issued by companies
- Issued at discount to maturity value
- Typical maturities between 30-90 days
- Unsecured
- Reduced liquidity
Fixed interest securities (bonds) characteristics
Debt instrument issued by government, companies, other bodies to raise money for long term borrowing
Bond owner receives regular interest and repayment of capital at maturity
Negotiable - can trade
Fixed rate of interest (coupon)
Fixed redemption value (par)
Fixed redemption date
Bond title
Name of issuer
Coupon
Maturity
Cum dividend
Purchaser receives full 6 months’ interest but pays accrued interest up to settlement date to seller
Ex dividend
Seller receives 6 months’ interest but price adjusted to reflect this
Dirty price
Price paid by purchaser = clean price +/- interest adjustment
Interest yield (or flat yield or running yield)
(Coupon / clean price) x 100
Bonds can trade above or below par
Doesn’t take account of any gain/loss if held until maturity
If coupon is above current interest rates and issuer is strong, they will trade above par
Redemption yield
Interest yield +/- gain (or loss) at maturity / years to maturity
______________________________________________
clean price
x 100
Redemption yield is more accurate as considers income and gain/loss at maturity
If redemption yield is less than interest yield, there will be capital loss at maturity
However, this ignores tax
No CGT on gilts and most corporate bonds for individual investors
Bond risks
Interest rate - when interest rates fall, capital values rice and vice versa
Liquidity - trade infrequently
Inflation - erodes capital values (bond prices tend to fall if inflation speeding up)
Currency - exchange rate movements for global bonds
Default - issuer may not pay interest / capital at maturity - investment grade (S&P’s BBB- or Moody’s Baaa3 or higher) vs sub-investment grade (junk bond - more volatile)
Market / systematic risk - economic factors or government actions
Factors affecting bond prices
Required yield determines market price - when interest rates go up, bond prices fall
Specific or commercial risks - government bonds more secure than non-government bonds
Market / systematic risk - economic changes affect fixed-interest securities
Volatility - lower coupon = more volatile, longer redemption period = more volatile, short dated + high coupon = less volatile
Yield curves
A way of comparing yields on bonds of different maturities as well as indication of market expectations.
Shown in graph form to represent relationship between bond’s redemption yield and period to redemption.
Normal yield curve - rising positive curve, higher yields for longer terms
Flat yield curve - income similar for long and short term, if economic factors are stable and no radical changes to expected inflation or interest rates
Inverted / reverse yield curve - yields on longer-term bonds are less than short-term bonds, caused by supply and demand or when investors expect short-term falls to interest rates and lower long-term rates
Index-Linked Gilts
Interest and capital repayment adjusted with inflation
Lower yields than conventional stock
Profits on disposal are CGT exempt but interest is taxable
What is the repo market
Repo is short for sale and repurchase agreement
One party agrees to sell gilts to another party with a formal agreement to repurchase equivalent securities at an agreed price on a specified future date
Transfer of assets - but operates as form of short term lending
Bank of England uses repo market to influence interest rates
What is the strips market
Separating conventional gilts into interest (coupon) and redemption payments which are then traded in their own right
A 5 year gilt can be stripped to make 11 separate securities (5 x 2 coupon payments + 1 redemption payment = 11)
Corporate bond types
Secured - charge on certain assets of the company
Unsecured - higher yield due to higher risk, holders rank alongside other creditors in liquidation
What are debentures?
Explain fixed charge vs floating charge?
Written acknowledgement of debt
Established by trust deed
Fixed charge - charged over specific asset which cannot be sold without debenture holder’s consent
Floating charge - general charge over company asset - lower priority for payment than a fixed charge
What are convertible bonds?
Unsecured loan stock offering holders the option of converting to ordinary shares
Interest paid in normal way until option exercised
Conversion dates and rates are specified
In the event of conversion, CGT is chargeable
What are floating rate notes?
Bonds which pay rate of interest linked to money market rate such as SONIA
Interest rate may be set as the average of SONIA over 6m period expressed as basis points above SONIA
Interest normally paid half yearly or quarterly
