CEMAP 1 Topic 6-Direct investments: cash and fixed‑interest securities Flashcards
Main Asset Classes
- Cash
- Property (eg BTL)
- Fixed interest securities (Gilts, corporate bonds)
- Equities (company shares)
Deposit based investments
Most used type of direct investment is a deposit account e.g bank or building society.
Investors place money in deposit‑based savings accounts for several reasons.
- Security of capital – some investors choose deposit‑based investments because they do not
want to put their capital at risk.
- Convenience – banks and building societies are readily accessible;
Banks and Building Society Accounts
Banks and building societies offer similar accounts, which fall into two basic categories:
- Current accounts, for everyday money needs;
- Savings accounts, where money not required for day‑to‑day spending is set aside
Traditional current accounts
A current account is a transactional account into which an individual can have their salary paid. Money can be drawn from the account or used to pay regular bills; via a debit card, a cheque book, electronic transfer, standing orders and direct debits.
Can arrange an overdraft and operate the account via the internet or phone, without the need to visit a branch office.
Basic bank account
A basic bank account is a simplified current account designed to encourage people who have not previously had an account to open one.
Cash can be obtained with a card from ATMs and from post offices. Payments can be made by direct debit but no cheque books are issued and there is no overdraft facility.
Interest‑bearing current accounts
Interest‑bearing current accounts provide investors with immediate access to their funds without loss of interest, in addition to
the usual current account services such as a cheque book, ATM facilities and overdrafts.
Can earn interest and receive cashback on spending on bills. Normally a minimum amount paid into the account each month and a
certain number of direct debits being paid out. Such accounts may also carry a monthly fee.
Instant access savings accounts
An instant access account can normally be opened with £1 and the account holder can have immediate access to their savings. The interest rate paid is comparatively low and is usually linked to the bank’s base rate. Such accounts may be suitable for short‑term ‘emergency’ funds.
Restricted access accounts
If access to an account is restricted, the provider has certainty that the funds are available to it for a longer period. Rates are therefore higher on this type of account than on an instant access account.
Access may be restricted by:
- limiting the number of withdrawals that can be made each calendar year;
- requiring a minimum period of notice be provided before funds can be drawn
- specifying an agreed period during which the saver may not access their money
National Savings and Investments
National Savings and Investments (NS&I) offers a range of saving and investment products backed by the government.
Offshore accounts
The term offshore is usually applied to any investment medium which is based outside the UK in a country that offers a more advantageous taxation of investments. Such countries include
the Channel Islands, Luxembourg and the Cayman Islands
Offshore investment can potentially expose an investor to greater risk than a
similar onshore investment:
- The account might not be denominated in sterling; if the investment is to be converted back to sterling its value might be affected by
unfavourable exchange rates
- Not all offshore accounts are protected by investor protection schemes.
The interest on an offshore deposit is paid gross. A UK resident must declare
the income to HMRC and may have to pay tax on it. However, if the country where the investment is held has a reciprocal tax treaty with the UK, and the interest has already been taxed overseas, tax relief may be available on some or all of it.
An introduction to Gilts
Gilts belong to a category of direct investment called ‘fixed‑interest securities’.
Their full name is ‘gilt‑edged securities’, and they are a form of borrowing by the UK government. Gilts are regarded as safe investments because the government is not expected to default on capital repayments or interest.
A gilt is categorised primarily according to the length of time left to run until its redemption. All gilts currently in issue have a specific redemption date,although, in the past, there have been undated gilts, with redemption at the
discretion of the government, and also dual‑dated gilts with redemption between two specified dates. A gilt with a coupon of 5 per cent and a redemption date in 2025 might be designated as Treasury 5% 2025.
Categories of Gilt
The UK Debt Management Office, which issues gilts, defines short and medium gilts as follows:
- Short‑dated gilts: less than 7 years.
- Medium‑dated gilts: 7–15 years.
Index‑linked gilts are gilts where the interest payments and the capital value move in line with inflation.
The government will make new issues of gilts, often when an existing issue has reached redemption. When a new issue is made,
investors can purchase those gilts. Once issued, gilts cannot be redeemed by investors prior to the redemption date but can be sold to other investors. The price at which they are sold depends on a number of factors:
- the level of market rates of interest;
- the amount of time left to redemption date;
- supply and demand.
Gilt prices are quoted either ‘cum dividend’ or ‘ex dividend’.
If a stock is bought ‘cum dividend’, the buyer acquires the stock itself and the entitlement to the next interest payment.
If the stock is bought ‘ex dividend’, the buyer acquires the stock but the forthcoming interest payment will be payable to the previous owner of the stock (ie the seller).
Gilt interest is paid gross without deduction of tax. The income is classed as savings income so would be tax free if it fell within an individual’s starting‑rate band for savings income or their personal savings allowance.
If the interest, when added to other savings income, falls outside the starting‑rate band for savings and exceeds an individual’s personal savings allowance it will be taxed at 20, 40 or 45% with the actual rate determined by the individual’s gross income.
Many investors who buy gilts do not intend to keep them until their redemption date. They buy them to sell for a profit. Alternatively, they may be able to buy gilts for less than par and then make a gain upon redemption. Any capital gains made on the sale or redemption of gilts are entirely free of capital gains tax (CGT)
BUYING AND SELLING GILTS
A higher‑rate taxpayer buys £100,000 par value of Treasury 5% 2025 at a price of 80.0, ie she pays £80,000 for the stock.
She receives half‑yearly interest of £2,500 (ie £5,000 annually), which represents a yield of 6.25 per cent on her investment of £80,000.
The interest is paid gross but she must pay tax of 40 per cent on any interest in excess of her personal savings allowance of £500.
Later she sells the stock for £90,000. There is no capital gains tax to pay on her gain of £10,000.
HOW DO INTEREST RATE MOVEMENTS AFFECT GILT YIELDS?
Rising interest rates
Robert owns £10,000 of gilts with a coupon of 3 per cent. This means that he receives £300 per year interest.
He wants to sell the gilts, which have six years to run until their redemption date. However, interest rates have risen since he bought them and new six‑year gilts are now being offered with a coupon of 5 per cent.
Carmen offers to buy Robert’s gilts from him, but she won’t offer him £10,000 for them because she can buy new six‑year gilts for £10,000 that gives her a coupon of £500 per year, instead of the £300 that Robert’s pay.
She offers him in the region of £9,000 for his gilts. The effect of rising interest rates is that the price on Robert’s gilts has fallen. Although a price of £9,000 would reflect a return of 3.33
per cent (ie £300 interest on £9,000 invested) in terms of the income provided by the gilts, it is important to remember that if Carmen buys the gilts and holds them until redemption she
will also make a capital gain of £1,000 as £10,000 is returned on redemption.
Falling interest rates
Imagine if, instead of rising, interest rates have fallen and new 6‑year gilts are only paying a coupon of 2 per cent. An investment of £10,000 would only return £200 per year, compared with the £300 per year that Robert’s gilts are paying.
Carmen may therefore pay Robert substantially more than £10,000, in which case Robert will make a profit (which is exempt from capital gains tax).
Carmen will need to bear in mind that if she pays more than £10,000 she will make a loss if she holds the gilts to redemption.
Running yield calculation for Gilts
Running yield = coupon ÷ price paid
Mark is considering buying gilts and is attracted to 5% Treasury 2025. He finds that this gilt is currently trading at a price of £130.73. Mark understands that, should he buy this gilt, he will get income of £5 per year (par value of £100 x 5%) every year to 2025.
He also understands that, should he hold the gilt until redemption date, he will suffer a loss of £30.73 on each one as only £100 will be paid on redemption.
To understand whether the income offered is a good rate it is necessary to calculate the running yield as follows.
Running yield = coupon ÷ price paid
£5 ÷ £130.73 = 3.82%
The 3.82% rate of income looks attractive, based on current interest rates, but it should be remembered that if the gilt is held to redemption it will lose £30.73 of capital value, which reduces the overall return.
Other fixed-interest stocks
Local authority bonds
Local authorities can borrow money by issuing stocks or bonds, which are fixed‑term, fixed‑interest securities. They are secured on local authority assets and offer a guaranteed rate of interest, paid half‑yearly.
The bonds are not negotiable and have a fixed return at maturity. Return of capital on maturity is promised, but these are not as secure as
gilts since there is no government guarantee.
Permanent interest‑bearing shares
Permanent interest‑bearing shares (PIBS) are issued by building societies to raise capital. They pay a fixed rate of interest on a half‑yearly basis. Interest is paid gross, although it is taxable as savings income according to the investor’s
tax status. Investors should note that PIBS rank below ordinary accounts in priority of payment, should a building society become insolvent. As a result, they are higher risk, because depositors will be paid before shareholders.
If a building society converts to a bank by ‘demutualising’, the PIBS it has issued are converted to perpetual subordinated bonds (PSBs). Perpetual subordinated bonds have similar characteristics to PIBS in that they have no redemption or maturity date and will provide a fixed income stream.
Corporate bonds
Companies can issue corporate bonds to meet its long‑term financing needs, or commercial paper if funds are needed over a shorter period.
Corporate bonds are issued with the promise to pay a fixed rate of interest until redemption date, with the loan repaid in full at redemption date.
The bonds can be bought by institutional investors (such as life companies and pension funds) and by private investors.
A bond may be secured or unsecured. If it is secured, a charge is made on company assets.
A bond that is backed by security is typically referred to as a debenture. The security is provided by a charge over company assets. A bond that is not backed by security is generally referred to as loan stock.
Some corporate bonds are convertible, giving the holder the right to convert the loan into ordinary shares of the issuing company. There is no obligation to do so and if the option is not exercised, the loan continues unchanged.
Interest, rather than dividends, is payable and the company is obliged to pay the interest promised, whether or not sufficient profit has been made by the company. Whether the bond is secured or not, the holder is a creditor of
the company so, in the event of the company being wound up, would have priority over shareholders. If the lending is unsecured, the bondholder ranks with ordinary creditors.
The risks associated with corporate bonds relate to the viability of the issuing company, its prospects and financial strength. Corporate bonds are riskier than gilts because gilts are backed by the government. Corporate bonds
will pay higher rates of interest than similar gilts. A bond that is unsecured presents a greater level of risk to the investor than one that is
secured.
Eurobonds
A Eurobond is a bond issued or traded in a country that uses a currency other than the one in which the bond is denominated. This means that the bond operates outside the jurisdiction of the central bank that issues that currency.
Eurobonds are a form of borrowing used by multinational organisations and governments. For example, a UK company might issue a Eurobond in Germany, denominating it in US dollars. It is important to note that the term has nothing to do with the euro currency, and the prefix ‘euro’ is used more generally to refer to deposits outside the jurisdiction of the domestic central bank.
Taxation of income
Local authority bonds, corporate bonds, PIBS and Eurobonds pay interest gross (without deduction of tax).
What is a structured deposit?
With a structured deposit, the return paid is linked to the performance of an index measuring the performance of equities, such
as the FTSE 100. The investment is normally arranged over a fixed term, five years for example.
The return generated through a structured deposit is variable because it is linked to the performance of a particular stock market index or indices. The benefit of using structured
deposits is access to equity‑based returns with a promise that, regardless of stock market performance, depositors will always get back their initial investment. This reduction in risk is offset by the lowered potential for reward,
meaning investors probably will not receive the full benefit of any index rise and they will not receive dividend payments.
What is ‘alternative finance’?
Alternative finance or peer‑to‑peer lending (P2P) involves a saver placing their money with a P2P lender who will then lend the money out to businesses that are seeking funding. This type of lending is usually arranged via aggregating
companies.
P2P lending is not a deposit proposition but has a number of elements in common with deposit‑based savings, notably that funds are aggregated and distributed, normally for a return, and it is possible to arrange both on an easy access and fixed‑rate basis over an agreed term. P2P lenders are regulated by the FCA.
In some cases, returns can be very competitive with traditional deposits but there are more risks. While the lender will perform due diligence on the businesses to which funds are being lent, there is a risk that loan repayments might be missed, in which case the returns to the saver would reduce.
Importantly, P2P lenders are not covered by the Financial Services Compensation Scheme.
