Cash Investments and Fixed-Interest Securities Flashcards
What are the main characteristics of cash deposits
- Investors receive regular interest on their deposit at a prevailing rate
- Investor’s capital is not exposed to investment risk
- The return comprises interest with no potential for capital growth
- Cash is a liquid asset that can be easily accessed
What are the risks of cash deposits
- Deposit-taking institutions are of varying creditworthiness - insolvency/defaulting
- Inflation reduces returns - real return could be negative
- Interest rates may fluctuate - returns vary over time
- Deposits in foreign currencies are subject to exchange rate movements
Instant Access Accounts
Give investors immediate access to their funds. Operated through branches, post, phone & online.
Characteristics:
- Investor can withdraw cash immediately via branch/card
- Rates are variable
- Highest rates are usually found on online accounts
Restricted Access Accounts
- Generally higher rates than for IAAs (highest available on cash investments)
- Higher risks due to restricted access (situations change)
- Main Types: Notice accounts, Term Deposit Accounts (Time deposits)
Foreign Currency Deposits
- Savings accounts denominated in a currency other than sterling
- Interest paid reflects prevailing market rate for the denomination currency
Offshore Sterling Deposit Accounts
- UK Branches of banks situated in tax havens
- Vary from variable rate instant access and notice accounts to term deposit accounts
- May pay higher interest rates than UK equivalent
- Not covered by FSCS
NS&I Direct ISA
- Only opened and managed online/by phone
- JISAs available
- Direct ISA is not flexible
NS&I Income Bonds
Pay a monthly income at a variable rate of interest with no risk to capital:
- Investors 16+
- Can be cashed at any time with no notice period or penalty
- Interest paid gross - taxable and can be set against a taxpayer’s PSA
NS&I Bank Account:
2 Types:
- Investment account managed by post only
- Direct saver that can be opened online/over the phone
NS&I Savings Certificates
- Only available to customers who have maturing certificates
- Not on general sale
- Can renew up to the total value of maturing certificate
Guaranteed Income Bonds
Characteristics:
- Fixed terms of 1, 2, 3 or 5 years - differing fixed rates for each
- Only available to customers renewing a maturing bond
- Minimum renewable amount is £500
- Interest paid gross and taxable - set against PSA
- Interest paid monthly
- Renewable by online/phone/post
Guaranteed Growth Bonds
Characteristics:
- Fixed terms of 1, 2, 3 or 5 years - different fixed rates for each
- Only available to customers renewing a maturing bond
- Minimum renewable amount is £500
- Interest paid gross and taxable - set against PSA
- Interest paid monthly
- Renewable by online/phone/post
Money Markets
Wholesale markets where banks, building societies, the Government etc lend and borrow from each other.
Short/Long term lending using short-term debt instruments.
Limited private investor involvement.
Types of Money Market Instruments
- Treasury Bills - issued by governments to finance short-term cash needs. Issued at a price that is less than their par/face value. Government pays holder full par value on maturity.
- Certificates of deposits - receipt from banks for deposits placed with them. Carry a fixed rate of interest (usually related to Sterling Overnight Index Average (SONIA)). Have fixed term to maturity. Can be traded in money markets.
- Commercial bills - short-term negotiable debt instruments issued by companies to fund their day-to-day cash flows. (Similar to TBs but less liquid).
Fixed-interest Securities
- Issued by Governments as a method of raising money to finance longer-term borrowing
- Owners are entitled to receive regular interest payments + a repayment of their capital at the end of a pre-determined period
- Cannot be cashed in before official maturity date - can be sold on the stock market
‘Negotiable fixed-interest, long-term debt instruments’
General characteristics of bonds
- Carry a fixed rate of interest (coupon)
- Fixed redemption value (par value)
- Repaid after a fixed period (redemption date)
Bond Yields
- All FIS bear a nominal rate of interest (the coupon)
- Yields measure the returns bonds provide in relation to their market price
- Interest yield & Redemption yield
Interest Yield
Expresses the annual income from a bond as a percentage of the price an investor would have to pay for the bond:
Coupon / Clean Price x 100
Aka: Running yield, flat yield, income yield.
Redemption Yield
- More accurate calculation of a bond’s yield
- Takes into account both income payments from the bond and capital gain/loss from holding the bond until maturity
- Adjusts value of each payment according to when it is received
IY +/- [(Gain/Loss to Maturity/Years to Maturity)/Clean Price x 100]
Risks of bonds
- Interest rate risk
- Liquidity Risk
- Inflation Risk
- Currency Risk
- Default Risk
Factors affecting bond prices
- Interest rate rises: bond prices fall due to a reduced demand. Coupon is fixed - yield adjusts upwards
- Interest rate falls: Price of bond rises due to increased demand - yield adjusts downwards.
- Price movements result in investors making capital gains/losses if they opt to sell before redemption
Volatility of bonds
- Bonds are sensitive to interest rate movements
- Lower the coupon, the more volatile the bond
- Longer the period to redemption, the more volatile the bond
Rationale: A greater amount of the cash flow from the more volatile bonds is received later in the bond’s life and is exposed to interest rate movements for a longer period.
Yield curves
- Provide a means for comparing yields on bonds of different maturities
- Give an indication of the market’s expectation of changes in interest rates (required future yields)
- Graph of the relationship that exists between a bond’s redemption yield and the period to redemption
Types of yield curve
- Normal yield curve
- Flat yield curve
- Inverted/reverse yield curve
Normal yield curve
Investors demand higher yields for holding longer-term bonds to cover the increased uncertainties over time.
Rising positive curve
Flat yield curve
- Economic factors deemed to be stable
- No radical changes to inflation/interest rates expected
- Investors prepared to accept a lower yield and pay relatively more for longer-dated bonds
- Can buy income income at almost any redemption period - no significant penalty for switching from longer-dated to shorter-dated bonds.
- Flat curve
Inverted or reverse yield curve
- Yield on longer-term bonds is less than on short-term bonds
- Expectations that interest rates will rise in the short-term, but will fall substantially in the future.
- Result of supply/demand that reduce yields on longer-dated bonds.
Gilts
- Fixed-interest securities issued by the UK government (via the DMO).
- Used to borrow money
- Categorised according to their time to redemption: (shorts, mediums and longs).
Index-linked gilt
- Differs from a conventional gilt in that the coupon payments and capital repayment are adjusted in line with inflation (measured by the RPI)
- Exempt from CGT however interest is taxable (including inflation uplift)
- Coupons & yields tend to be lower than conventional bonds
- Pre-September 2005 - Use RPI 8 months before each payment date
- Post September 2005 use RPI three months before each payment date
Repo market
- Where gilts are bought & sold
- Repo = Sale and repurchase agreement
- One party agrees to sell gilts to another with a formal agreement to repurchase equivalent securities at an agreed price on a specified future date.
Strips market
- ‘Separate trading of registered interest and principal securities’
- Process of separating a conventional interest-bearing gilt into its individual interest (coupon) and redemption payments
- Can be separately held and traded in their own right
Corporate fixed-interest securities
Companies can issue fixed-interest securities to borrow money at fixed rates of interest for long periods of time.
Corporate bonds vs Gilts
- CBs are riskier
- CBs are typically more volatile
- Lower quality bonds (smaller companies) may be difficult to trade
- Larger buy/sell spread for CBs
- Company creditworthiness constantly changes, unlike Government
- CB prices can very even with interest rates/inflation constant
- CBs have generally higher yields - reflect their increased credit risk/lower liquidity
Types of corporate bond
- CBs may be secured or unsecured:
- Secured CB: Charge on certain assets of the issuing company. If the company falls into arrears with interest payments/defaults, assets can be seized and sold to repay the loan.
- Unsecured CB: No asset acting as collateral. Holder ranks for repayment alongside ordinary creditors.
Secured loans rank above unsecured loans when winding up.
Debentures
A secured loan agreement between a lender and a borrower with business assets used as a security.
Agreement includes:
- Interest rate, payment dates and redemption date
- Assets backing the debenture
- Any conditions imposed on the borrower (e.g. restricting the total amount of money the company can borrow by imposing a maximum ration of debt to share capital etc)
Secured by one/both of the following:
- A fixed charge
- A floating charge
Convertible bonds
Usually unsecured loan stock that offers the holder the option of converting the bond into ordinary shares of the issuing company under specified terms and conditions
Floating rate notes
- Bonds issued by companies (banks/financial institutions) which pay a rate of interest that is not fixed but instead linked to a money market (e.g. SONIA)
- Coupon is reset every quarter to a specified level over the reference rate
- If interest rates rise, FRN also rises
Difference between NS&I Income Bonds vs Guaranteed Income Bonds
Variable interest rates
Bonds - Cum Dividend
- Purchaser receives the full six months’ interest
- Buyer compensates seller by paying more
- Pays clean price + accrued interest up to date of purchase (dirty price)
Bonds - Ex Dividend
- Interest payments made to whoever holds the bond 7 days before the interest payment date
- Bonds purchased after interest payment dates
- ## Price adjusted to reflect no interest
