Cash, bonds, and Gilts

Question 1

How is the Annual Percentage Rate (APR) calculated if the monthly rate is known and how would it be calculated on a monthly basis if the annual rate was already known?

What is the AER/APR?

Answer 1

APR = (1+monthly rate)^12 -1

Monthly rate = 12sqr(1+APR)-1)

The annualised rate allowing for the frequency at which interest is paid is referred to as the AER or the effective annual rate

Question 2

Features of NS&I Direct ISA

Answer 2

• NS&I Direct ISAs can only be opened and managed online or by phone.
• Junior ISAs can only be opened and managed online.
• The Direct ISA is not a flexible ISA, i.e. NS&I has not adopted the flexible ISA rules

Question 3

Features of NS&I Income Bonds

Answer 3

• Pay a monthly income at a variable rate of interest with no risk to capital.
• Investors must be aged 16 or over.
• NS&I Income Bonds can be cashed in at any time with no notice period or penalty.
• Interest is paid gross but is taxable and can be set against the personal savings allowance.

Question 4

Features of NS&I bank accounts

Answer 4

1. an Investment Account managed by post only; and
2. a Direct Saver that can be opened online or over the phone.

Question 5

Features of NS&I Savings Certificates

Answer 5

Only available to customers who have maturing certificates. They are not on general sale.

Those customers can renew up to the total value of their maturing certificate, including earned interest.

Or they can cash in some of the investment and renew the balance

Question 6

Features of NS&I Guaranteed Income Bonds

Answer 6

• investors must be aged 16 or over;
• there is a fixed term of one year;
• the minimum investment amount is £500;
• interest is paid gross but is taxable and can be set against the personal savings allowance
• interest is paid once a month.

Question 7

Features of Guaranteed Growth Bonds

Answer 7

• investors must be aged 16 or over;
• there is a fixed term of one year;
• the minimum investment amount is £500
• interest is paid gross but is taxable and can be set against the personal savings allowance.

Question 8

Features of Green Savings Bond

Answer 8

• investors must be aged 16 or over;
• issue 4 fixed interest of 4.20%;
• three-year fixed term;
• invest up to a total of £100,000 per person;
• interest is added on each anniversary;
• interest is paid gross but is taxable and can be set against the personal savings allowance.

Question 9

What are government T-Bills

Answer 9

Via the DMO the government borrows money from mainly 3 months, but can be 1 month or 6 months.

Routinely issued at weekly auctions and have maturities of one, three or six months.

their rate of return is used to benchmark risk-free rate of return.

Question 10

What is inflation risk?

Answer 10

Risk of losing value as inflation increases.

Question 11

What is interest rate and reinvestment risk?

Answer 11

The risk that the return earned will vary depending on movements in interest rates.

Reinvestment risk. The original investment may be made at a time when interest rates are high, but following maturity of the original deposit, rates may have fallen and it may not be possible to secure the same level of interest.

Question 12

What is deflation and what are the key points surrounding it?

Answer 12

A decrease in the price level of goods and services, or when the annual inflation rate is below 0%.

Fall in demand/reduction in economic activity.
Greater tendency to save/borrow less.
Debt increases in value.

If the supply of goods rises faster than the supply of money, the purchasing power of money increases and the general price level of goods falls.

Consumers become reluctant to buy expensive items, such as cars and homes, as they know these will be cheaper in the future.

Once deflation occurs, it is self-perpetuating, as reduced output and profits will lead to businesses cutting their workforce, creating unemployment.

Question 13

State and describe the type of money market funds

Answer 13

Short-term money market funds
Invested in short-term debt and money market instruments and have a weighted average maturity of no more than 60 days and a weighted average life of no more than 120 days.

Standard money market funds
Aim to make slightly higher returns and therefore invest in assets with extended maturity periods of six and twelve months.

Question 14

What are the uses of a money market fund?

Answer 14

• a short-term home for cash in times of market volatility;
• an alternative to savings accounts, but not while short-term interest rates are kept deliberately low; and
• a home for the cash element within a portfolio’s asset allocation strategy.

Question 15

What are the risks posed by money market funds and how are these somewhat mitigated?

Answer 15

Money market funds carry many of the same risks as other cash investments: credit risk, inflation risk and interest rate risk, and may also have currency risk.

Holding funds in a cash investment exposes the investor to the risk of failure by the bank or savings institution.

Money market funds invest in a range of instruments from many providers, diversifying the risk of a single institution failing.

Risk depends on the types of instrument invested and the credit rating of issuing institutions.

Question 16

How is the following bond name interpreted:

‘2% Treasury Gilt 2025

Answer 16

The title tells us that the issuer is the UK Government (HM Treasury) and that the bond will mature in the year 2025.
The 2% coupon means that for a £1,000 nominal holding of this bond, the Government will pay £10.00 every six months until it is finally repaid in 2025

Question 17

What is the key factor of Eurobonds?

Answer 17

The defining characteristic of Eurobonds is that they are denominated in a currency different from the financial centre (or centres) in which they are issued

Question 18

What is the break-even inflation rate?

Answer 18

the rate of inflation that gives the same real net redemption yield for an index-linked gilt and a comparison conventional gilt of similar maturity for investors in a given tax rate, 20%, 405 45%.

Above the break even rate, the index linked gilt gives the better return.

Below the break even rate, the conventional gilt gives the better return.

Question 19

What is a convertible bond?

Answer 19

They give the investor the right to convert the bond into a pre-defined number of ordinary
shares in the issuing company, on a set date or dates or between a range of set dates, prior
to the bond’s maturity

Question 20

How do you calculate the conversion premium/discount?

Answer 20

(market price of convertible stock / (conversion ratio x market price of shares) - 1) x 100

Question 21

calculate the conversion premium/discount where:

A company has issued a 5% convertible unsecured loan stock at £100 nominal. This can be converted into the company’s ordinary shares at a rate of 25 ordinary shares for every £100 nominal of the loan stock.

Let’s assume that the bond is trading at 110p to yield 4.5% and that the ordinary shares are priced at 400p:

Answer 21

bond = £100 (parr) x £1.10 = £110 market value

shares = 25 x £4,00 = £100 market value

conversion premium:

£110 / (25 x £4.00) - 1 x 100 = 10%

the convertible is at a premium to the ordinary shares, and so buying the convertible bond is a more expensive route than buying the ordinary shares directly. The higher the premium, the more the convertible loan stock will behave like a conventional stock.

If the price of the convertible stands at a discount to the price of the ordinary shares, then it would be a less expensive way of buying into the company’s ordinary shares or may be worth converting.

The lower the premiums, the nearer the loan stock will be to conversion and therefore, the closer its price movements will be to that of the company’s equity.

Question 22

What are the risks of buying foreign bonds?

Answer 22

Credit/default risk
Economic risk
Foreign Exchange risk
Interest rate risk
Liquidity risk
Political risk

Question 23

What are the main risks of holding either corporate or government bonds?

Answer 23

Credit risk - payment of coupon and capital may not be made

Market risk - inverse relationship between bond prices and interest rates

Inflation risk - real value of bond coupon and redemption repayment

liquidity risk - bond not easily traded

exchange rate risk

Question 24

State the 3 types of credit risks for bonds

Answer 24

Default.
Downgrade.
Credit spread.

Question 25

How is the coupon on an index linked bond calculated, which has an indexation lag?

Answer 25

• Take Retail Price Index (RPI) value.
• Three months prior to coupon date.
• Divide by RPI set at issue date.
• Apply to the coupon.
• Divided by two/paid half yearly.

Question 26

Why would the redemption yield on a gilt be negative?

Answer 26

• High demand.
• Expectation of rising future inflation.
• Gilt trading above par after allowing for indexation since issue.
• Low coupon does not offset real loss.

Question 27

Explain a new Gilt issue would be priced in order for the interest rate to redemption to be negative

Answer 27

• Issued at a price higher;
• than par/nominal/redemption price.
• No coupon or low coupon which does not offset the capital loss.

Question 28

What is the difference between a clean and dirty price?

Answer 28

Clean = real price, dirty = paid on the market

difference is the accrued interest that the bond holder becomes entitled to on the next distribution date - or the seller is losing by selling before the distribution date and the dirty price compensate for this loss.

Dirty price = clean price + accrued interest (AI) at point of sale.

AI = coupon x (days from last coupon / days between coupons)

Question 29

There is an inverse relationship between bond prices and yields/interest rates, what is this?

Answer 29

• When interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with the new higher interest rate.
• When interest rates fall, prices of outstanding bonds rise until the yield of older bonds is low enough to match the lower interest rate.

Question 30

What is the running yield or interest yield?

Answer 30

expresses income from a bond as a percentage of the price an investor would have to pay for the bond.

(coupon/clean price) x 100

Question 31

Formula for Simplified Redemption Yield, otherwise known as gross Japanese method?

Answer 31

Interest yield + or - (gain or loss to maturity / years to maturity) / clean price x 100

Question 32

How would you calculate the Net Redemption Yield?

Answer 32

subtract income tax from running yield, i.e.

A higher rate investor purchases a 10 year 6.5% coupon bond for a market price of £93.

Flat yield = 6.5/93 = 6.99% = Gross flat yield

6.99% x 0.6 = 4.19 = net Flat yield for 40% tax payer

Question 33

Calculate net income of a bond using the running yield formula.

Answer 33

purchase amount / clean price = stock amount

stock amount x coupon = gross income

gross income - tax = net income

net income return = net income / purchase amount x 100

i.e. Charles, basic rate taxpayer, purchases £10,000 of 3.8% 2024 stock priced at £112.50, what is the net income and net income return?

£10,000 / 0.11250 = £8,888.89 of stock

£8,888.89 x 3.8% = £337.78 of gross income

£337.78 x 0.8 = £270.22 = net income

£270.22 / £10,000 x 100 = 2.7022% = net income return.

or……

3.8 / 112.50 x 100 = 3.37% x 0.8 = 2.7022 = net income return

Question 34

Key thing to remember with regards to interest yields and redemption yields

Answer 34

minus the redemption yield from the interest yield to provide an approximate yield to redemption.

If the redemption yield is less than the interest yield, there will be a capital loss if the bond is held until its redemption date. If the reverse is the case and the bond is priced below par, the redemption yield will be higher than the interest yield as the return will incorporate the gain if held until redemption.

Question 35

Calculate the dirty price of a bond

Answer 35

dirty price = clean price + accrued interest

accrued interest = coupon x (days from last coupon / days between coupon)

Question 36

Which types of bond are the most volatile?

Answer 36

The longer the period to redemption, the more volatile the bond

The lower the coupon, the more volatile the bond.

most volatile = long and low

Question 37

What is Macaulay Duration otherwise known as Duration and how is it calculated?

Answer 37

compares the volatility of price between bonds with varying incomes, time to redemption and mix of returns.

• Weighted;
• average term/number of years;
• discounted/present value of;
• all cash flows/coupons + redemption value;
• from a bond.

sum of (NPV of the bonds cashflow x time to cashflow being received) / sum of (net present value of cashflow to be received)

Question 38

What is the modified duration (MD) of the bond and how is it calculated?

Answer 38

• Measures sensitivity of;
• a bond’s price;
• yield to maturity/redemption yield/interest rates.

estimates how much a bond’s price will change if there is a change in interest rates. Quantifies sensitivity of bond’s price to changes in GRY.

D / (1 + r)

D = duration
r = present yield

so for a 1% change in yields the bond price will change by MD

Question 39

State one reason why a fixed interest fund manager would use Macaulay duration and one reason why a fixed interest fund manager would use modified duration within a bond fund.

Answer 39

Macaulay
* Portfolio immunisation/liability matching/hedging out interest risk/predict returns.

Modified
* Reduce duration/interest rate risk.

Question 40

Factors an investor should be aware of when assessing Macaulay duration figures across different bond funds

Answer 40

Macaulay is relative/can be used to compare funds.
* Affected by coupon/price.
* Becomes less accurate as change in yield increases.
* Assumes linear relationship between interest rate and bond price.
* May not reflect fund style/mandate.

Question 41

using MD how would you calculate the change of the bond price given a change of in GRY or interest rates?

Answer 41

bond price - (bond price x MD)

For a 1% rise in GRY (or interest rates) on a £97.28 bond with an MD of 2.74, the price would be…

£97.28 - (£97.28 x 0.0274) = £94.61

Question 42

Describe and explain a normal yield curve

Answer 42

Investors demand higher yields for longer term bonds to cover increased risks and unknowns that longer redemption times brings.

This is known as liquidity preference - need to be rewarded for tying up capital.

Shape = rising slope.

• Longer dated bonds;
• yield more;
• than shorter dated ones.
• Economic optimism/long term interest rates/inflation will be higher.

Question 43

Describe and explain flat yield curve and what does it mean for the prospect of the economy?

Answer 43

Longer dates bonds have same interest rates as shorter dated/interest rates not
expected to rise.
* Expected that inflation will not increase.
* Slow economic growth/Low economic growth.

Question 44

Describe and explain inverted or reverse yield curve

Answer 44

The yield on longer-term bonds is less than on short-term bonds. This can be caused by investor expectations that interest rates will fall in the short-term, while long-term interest rates are expected to be substantially below current levels.

It can also be a result of factors connected with supply and demand that reduce the yield on longer-dated stock.

Question 45

Risk of holding bonds

Answer 45

Credit risk: the risk that interest payments and the repayment of the original capital may not be made.

Market or price risk: the risk that movements in interest rates have a significant impact on the value of bond holdings.

Unanticipated inflation risk: the risk of inflation rising unexpectedly and the effect it will have on the real value of the bond’s coupon payments and redemption payment.

Liquidity risk: where bonds are not easily or regularly traded and can be difficult to realise at short notice or can suffer wider than average dealing spreads.

Exchange rate risk: where bonds are denominated in a currency different to that of the investor’s home currency and so, are potentially subject to adverse exchange rate movements.

Question 46

Identify the main benefits of owning a gilt-based collective fund in comparison to a single gilt on a direct basis.

Answer 46

• Active management.
• Diversification;
• across yield curve/maturities/durations.
• Can invest in new gilts at issue.
• Access to market participants.

Question 47

Identify the main drawbacks of owning a gilt-based collective fund in comparison to a single gilt on a direct basis.

Answer 47

• Exposed to duration risk/manager gets it wrong.
• Loss of known redemption date/yield/coupon.
• Investor protection limited to £85,000.
• Subject to CGT upon disposal.
• Daily dealing.
• Fund charges.