Cash and fixed interest securities

Question 1

What are the different types of risk?

Answer 1

Currency Risk

Interest Rate

Liquidity Risk

Counterparty

Regulatory

Income

Inflation

Shortfall Risk

Systematic and non-systematic risk

Question 2

What are the general characteristics of cash deposits?

Answer 2

• Investors receive regular interest on the deposit
• Investor’s capital is not exposed to investment risk
• The return is just interest income with no capital growth
• Assets are liquid

some accounts which offer higher interest rates may impose penalties on withdrawals or have notice periods. penalties are:-

• loss of interest differentials (i.e. the rate drops to the standard)
• loss of interest for the period of notice required
• for NS&I products no interest at all if surrendered in 1st year.

Question 3

What risks are associated with cash?

Answer 3

Default Risk

Inflation Risk

Interest Rate Risk

Currency Risk

Question 4

What considerations should you have to judge the level of default risk?

Answer 4

Creditworthiness of bank.

i.e. look at it’s credit rating with Standard & Poor.

Compensation scheme

Is the bank a member of FSCS? Remember that if accounts are held in subsidiaries of a larger group and only the parent is authorised then the first £85,000 overall is protected.

Also only covers EEA and not Channel Islands or Isle of Man.

Question 5

What considerations should you have to judge the level of inflation risk and interest rate risk?

Answer 5

Inflation Risk

Long term investors may find that the final sum paid our including interest will purchase less than the original sum would have done when invested.

Interest Rate Risk

A variable interest rate account is dependant on the base rate. Even fixed term deposits are vulnerable if rates fall at time of maturity so they cannot reinvest at the same level.

Question 6

What considerations should you have to judge the level of currency risk?

Answer 6

• High interest rates means high inflation in the country which could collapse.
• Currency rates fluctuate so are no guarantee of return
• Many countries don’t have the same supervisory structures as UK.

Consider

1. what the market thinks will happen ove rthe lifetime of the investment?
2. the currencies past volatility against major currencies
3. If the investment is at a variable rate don’t forget to consider interest rates
4. Will the bank have the funds to pay out on maturity?
5. Is there any compensation scheme and what limits does it have?

Question 7

What is a structured deposit account?

Answer 7

An account that pays interest based on the performance of an equity index (usually FTSE 100). Typically provides a return over a fixed term which isthe greater of:-

• the original investment
• a multiple (e.g. 100%) of the change in the FTSE 100

Usually require being tied in for 5 years so inflation risk

_{an example is NS&I Guaranteed Equity Bond.}

_{Different from other <strong>structured products</strong> as the deposit taking firm has the obligation to repay the depositor rather than where a wrapper offers a structured product and so the <strong>default risk</strong> is with the third party that issues the debt securities not the company offering the wrap.}

Question 8

What are offshore sterling deposit accounts?

Answer 8

Generally available from UK branches of banks & building socities situated in tax havens such as Channel Islands or Isle of Man. Various types of accounts which usually pay interest at a rate higher than UK equivalent accounts and pay gross.

Question 9

Cash Isas

Answer 9

• £5,760 for 13/14
• previous years investment can be transferred in part or whole
• current tax year’s investment must be transferred in whole
• cash can be transferred to another cash or stocks & shares ISA
• If transferred to Stocks & shares it is treated as though invested directly in stocks & shares and as if the Cash ISA subscription had never existed
• you cannot transfer cash from Stocks & Shares ISA to cash ISA

Eligible investment include

• OEICS
• Unit Trusts
• stakeholder cash deposit products
• Non qualifying life assurance policy
• Undertakings for Collective Investments in Transferable Securities (UCITS)

Question 10

What are Money Market Investments?

Answer 10

Money Markets are where banks etc lend and borrow from each other. It plays an essential role in government finances and the banking industry and provides short term capital from companies.

They allow issuers to raise funds for short term (fixed) periods at relatively low interest rates (also fixed).

Lenders can sell the security in the money market at any time so provides them with instant access.

Question 11

Are Money Market Investment Vehicles suitable for your client?

Answer 11

Direct investment from individuals is unlikely due to amounts required. Funds are created to pool together all investors’ funds. Some funds are just cash but others are more complicated.

Consider:-

How do returns compare with other cash based investments?

What are the charges and how do they impact returns?

How long will it take to realise an asset if neccessary?

What are the underlying assets and what risk is the fund exposed to?

How experienced is the fund management team?

Question 12

Types of Money Market Instruments

Answer 12

• Treasury Bills
• Certificates of Deposit
• Commercial Bills

Question 13

What are Treasury Bills?

Answer 13

• Issued by Debt Management Office of HM Treasury to finance short term cash needs via weekly auction.
• Have maturities of 1, 3 or 6 months
• Can be bought by the public (Min £500,000)
• Don’t pay interest. Issued below par and par value paid at maturity.
• Risk Free and used as benchmark “risk free rate of return” when measuring the risk premium of other financial instruments

Question 14

What are Certificates of Deposit?

Answer 14

• Receipts from banks for deposits placed with them
• Fixed rate of interest. Yield depends on market rates and credit rating of the bank.
• Fixed Term (usually 1-3 months) and cannot be withdrawn early
• Lower yields than on ordinary deposits as they can be traded so easier access to capital.

Question 15

What are Commerical Bills?

Answer 15

• Short term negotiable debt instruments from companies. Used to fund day to day cashflow.
• Issued at discount to maturity value (similar to Treasury Bills).
• unsecured so usually on from companies with high credit rating
• higher yield than Treasury Bill as more risk and less liquidity.

Question 16

What are Fixed Interest Securities?

Answer 16

Issued by Government or companies to finance longer term borrowing requirements. Known as stock,loan stock,debentures,securities, loan notes. Gilts and corporate bonds signify loans to particular types of borrowers.

They pay out regular interest payments and return capital on maturity.

Negotiable: after buying the security the lender can sell the entitlement to interest and capital to 3rd party who can also sell.

Fixed interest: Borrower committed to pay interest at fixed rate for duration

Long term: typically 2 - 30 years

Debt instrument: they represent borrowing

Question 17

Characteristics of Fixed interest securities

Answer 17

Bond Title

1. issuer’s name
2. coupon. (i.e. fixed interest rate usually paid out every 6 months)
3. maturity date (when nominal value repaid to whomever holds the bond at that time). Two dates means the borrower can chose, giving at least 3 months notice.

Question 18

Pricing & Trading Fixed Interest Securites

Answer 18

Bonds are traded by par value. Prices are quoted per £100 nominal value of stock although any amount can be purchased.

Interest usually paid twice a year to whomever holds the stock 7 working days before interest payment date.

With (cum) dividend

Purchaser receives full 6 months interest even though they didn’t hold the stock for the whole time.

Cost = Clean price plus interest accrued

Without (ex) dividend

Seller keeps dividend if sold between before dividend payment but after qualifying date.

Cost = clean price minus interest accruing from sale.

Clean price +/- interest = dirty price!

Question 19

Bond Markets - Primary Market

Answer 19

Debt Management Office auctions gilts weekly.

• Large investors bid at price & quantity they want
• Successful bidders pay the price they wanted
• Individuals bid up to £500,000 and are allocated stock at the average of accepted prices.

Companies issue less frequently and market them to potential investors. Investors place indicative bids at a certain price and once terms agreed they have 24 hours to finalise the bid.

Question 20

Bond Markets - Secondary Market

Answer 20

Government sector

Uk Government is biggest borrower in UK bond market

Corporate Sector

Sterling loans to foreign borrowers

Eurobond market

Eurobond is an international bond in a currency other than that of the country it is issued. (e.g. British Company issues Eurobond in USA in Yen). Bond named according to currency it is issued in ($US = Eurodollar bond). Used by World Bank

Question 21

Bond Yields - Interest Yield

Answer 21

Annual income as a % of price

Can mislead as bond may provide a capital gain or loss at redemption

coupon/clean price X 100

Question 22

Redemption Yield

Answer 22

More accurate.

_Gain(or loss) to maturity ÷ years to maturity _

                     Clean price                                    x 100

If Redemption Yield is less than Investment Yield there will be a capital loss at redemption. Remember interest is taxable but capital is not so you can have two similar redemption yields with different net benefits to the individual

Question 23

Risks

Answer 23

Interest Rate risk

a rise in interest rates means a fall in capital value.

Liquidity Risk

Inflation Risk

Currency Risk

Default risk

Market or systematic risk _{if expectations of inflation diminish the bond prices go up and they fall if rate of inflation is deemed to be speeding up}

Question 24

Volatility of Bonds

Answer 24

The lower the coupon the more volatile the bond.

The longer till redemption the more volatile the bond.

this is because a high coupon means you get a return for your investment more quickly than with a low coupon (where you are more reliant on maturity).

A shorter bond doesn’t have the benefit of time to recover from fluctuations in the market.

Question 25

Normal Yield Curve

Answer 25

The more pessemistic about future inflation and interest rates, the steeper the curve as investers want a high yield to compensate.

If you want an income this curve means you need more capital to achieve the same income in short dated bonds than in longer dated bonds

Question 26

Flat Yield Curve

Answer 26

Stable Economy. No real difference in price for longer or shorter redemptions so no significant penalty for switching between the two

Question 27

Inverted Yield Curve

Answer 27

Yield on longer term bonds less than on shorter term.

When interest rates in the short term are expected to rise but then fall below current rates in the long run

Or supply and demand on longer dated stock. less stock increases prices which reduces yield

Question 28

Index Linked gilts

Answer 28

Uses RPI and will fall if RPI falls.

• Each interest payment is revised in line with monthly change in RPI over previous 6 months
• Capital repayment reflects changes in RPI from date of issue to redemption
• lower yield and coupons reflect that they will rise in future.
• Yields can’t be calculated in usual way as they aren’t fixed. 3% inflation assumed in press.
• Disposal is CGT free but all interest, including inflation uplift is taxable.

Question 29

Repo Market

Answer 29

Sale and Repurchase agreement. _{<em>basically a loan</em>}

Used by BoE to influence market rates

Agree to sell but then repurchase the equivalent securites at an agreed price on a specified future date

The longer the term the higher the repurchase costs to reflect the greater interest costs

in practice the gilts are used as security for a short term loan rather than actually being transferred. In that way the seller gets to retain exposure to gilts and has a decent loan interest rate without incurring transaction costs

If not repurchased on due date the lender takes ownership

Question 30

Strips Market

Answer 30

Separates conventional interest bearing gilt into coupon and redemption payments which can be held and traded separately.

Coupon dates of 7 March & 7 September

(e.g. 10 year gilt stripped to 21 segments. 20 entitled to 1 half yearly interest payment and 1 redemption payment in 10 years)

No regular interest instead the investor get’s the strips face value on maturity. So they trade at a discount to face value.

Question 31

Corporate Bonds - Types

Answer 31

Secured

or

Unsecured

In addition there may be upper limit on the total amount the company can borrow or they may need to stay within certain financial ratios

Question 32

Debentures

Answer 32

Established by Trust Deed. Secured with Fixed or Floating Charge

Corporate Trustee acts for lender to protect borrower.

Deed includes

• terms of issue: interest rate, payment and redemption dates
• assets backing the bond
• powers of trustees
• any conditions imposed by borrower e.g. max ratio of debt to share capital

Question 33

Convertible loan stock

Answer 33

Unsecured loan stock with option to convert to ordinary shares under specific conditions

usually have lower interest rates due to conversion option.

rights to convert vary as does the number of shares to be received (this can be fixed or varied)

A rise in share price could cause the convertible loan stock to rise. A drop should never result in the loan stock falling below the value of straight loan stock.

if not converted by expiry date the stock reverts to conventional loan stock.

No CGT exemption. Lossess can be set against gains.

Question 34

Floating Rate Notes

Answer 34

pay interest linked to a money market rate such as LIBOR

e.g. average of LIBOR over a 6 month period

expressed as basis points (hundredths of one percentage point) above LIBOR

e.g. LIBOR plus 50 basis points = addition 0.5%

coupon paid half yearly or quarterly at rate determined at beginning of each coupon period

Prices tend to stay close to nominal value as interest rate changes only affect the interest rate on the stock itself.

Question 35

PIBS & PSB

Answer 35

no obligation to be redeemed

undated so long term and sensitive to interest rate changes

not covered by FSCS

Company goes into liquidation? Forget it!

interest payment missed are not made up later

Higher yield than normal undated gilt due to lack of security.

Interest paid half yearly and gross but subject to Income Tax

CGT EXEMPT