Ch1: Cash investments and fixed interest securities Flashcards
What are the main characteristics of cash deposits?
1) Investors receive regular interest on their deposit at the prevailing rate
2) The investor’s capital is not exposed to investment risk (will be eroded by inflation)
3) The return simply comprises of interest, with no potential for capital growth
4) Cash is a liquid asset
What is AER?
Annual Equivalent Rate is the annual rate of return when interest is credited more than once a year, taking into account the effect of compounding
Who are the major deposit takers?
Banks, building societies, credit unions, UK Gov (NS&I)
What is the term/rate of fixed-term deposits made in the money markets?
- Term can range from overnight to one year
- Rates are based on those that can be obtained in the money markets, as measured by London Interbank Offered Rate (LIBOR).
What are the types of penalty of a fixed-term deposit account?
Penalties for notice periods/minimum balances. Types of penalty:
- Loss of the interest differentials that were being provided for larger or long term deposits
- Loss of interest for the period of notice required on the account
What are the three main types of risk facing cash investments?
- Default risk
- Interest rate risk
- Inflation risk
What two things should be assessed with respect to default risk of an institution?
- The creditworthiness of the bank/building society
2. The extent to which a compensation scheme will protect the deposits
How can you assess the creditworthiness of a bank/building society?
Look at it’s credit rating as issued by agencies such as Standard & Poor’s, Fitch Ratings.
What do credit ratings do?
Principally assess the default risk associated with bonds issued by Government’s/Companies. Also give an indication of a bank or building soc’s ability to repay debt/stability.
What does the FSCS protect?
-£85k per investor with one bank/branch (2 x if joint account holders)
Which areas does the FSCS not cover?
Does not cover outside EEA/Channel Islands/Isle Of Man
(Index linked gilts) what is the RPI based on for a gilt after Sep 2005??
3 months before
(Index linked gilts) what is the RPI based on for a gilt before Sep 2005??
8 months before
What is a coupon?
Rate of interest on £100 nominal value of stock
What increases gilt volatility?
More volatile = lower coupon, longer to redemption
What is the DMO’s classification of gilts?
Short <7 years
Medium 7-15 years
Long 15+ years
What is the financial press classification of gilts?
Short <5 years
Medium 5-15 years
Long 15+ years
How long does the FSCS aim to pay compensation?
7 days or 20 working days for complex case
What is interest rate risk (cash)?
The return earned will vary depending upon movements in interest rates.
What is reinvestment risk (fixed term deposit)?
The original investment may have been made at a time when interest rates were high but at the end of the fixed term, rates may have fallen, and it may not be possible to secure same level of interest
What are the common dangers of off-shore accounts
- High rates of interest may be offered by high inflation countries with collapsing currencies
- Strong currencies do not continually strengthen
- Some countries do not have same level of supervisory structure as the UK
What factors should be considered when investing in foreign currency accounts?
- Expected movement in currency against sterling
- Volatility of the currency’s past value against major currencies
- (If detail of foreign currency are not easily available) the prospect for sterling generally over the relevant period
- Likely changes in interest rate if variable
- Ability of deposit-taking body to repay capital
- Whether there are statutory or industry compensation schemes, the level of payment and the circumstances in which they are paid
Who are foreign currency accounts most suitable for?
People who want income in a particular currency
What are the main characteristics of an instant access account?
- Investor can withdraw cash immediately via branch or cash card
- Rates are variable
- Highest rates usually found on postal, telephone or online accounts
What are the main characteristics of restricted access accounts?
- Rates generally higher than instant access
- Risk are higher because of restricted access
What are the two main types of restricted access account?
- Notice account
- Term deposit
What is a structured deposit
Pay interest based on the performance of an equity index.
Structure offer investor return which is greater of: original investment or % change of the change in FTSE 100.
How does the protection on a structured product differ from a structured deposit?
A structured product usually relies on third party who issues debt securities to be held within the structured product wrapper, and so the investor is exposed to the risk of default to the counterparty. Structured deposit has an obligation to repay depositor.
Where are offshore accounts typically held?
Tax havens such as Channel Islands or Isle of Man
What is the annual subscription limit of an ISA?
£20,000
What are the ISA flexibility rules?
Withdrawals can be made and amount replaced in same tax year with no impact on annual subscription
What are the rules with transferring money (in a cash ISA) from the current tax year?
Whole amount saved year-to-date must be transferred
What can cash ISAs be transferred to?
Another cash ISA, a stocks and shares ISA (if over 18), and an innovation finance ISA.
What can a stocks and shares ISA be transferred to?
Cash ISA
What can a help to buy ISA be transferred to?
LISA
What are eligible investments of a cash ISA?
- Bank/building society accounts
- Units or shares in UK authorised unit trusts and OEICs
- Units or shares in a unit trust, OEIC, UCITs or a life assurance policy that would be likely to return at least 95% of investors original capital within 5 years
- NS&I Direct ISA
- Stakeholder cash deposit products
What are the features of a NS&I Direct ISA?
- Can only be opened/managed online or by the phone
- JISAs can only be opened and managed online
- Transfers from other providers are not permitted
- Not a flexible ISA
What are the features of NS&I Income Bonds?
- Pay monthly income at a variable rate with no risk to capital
- Investors must be paged 16+
- Can be cashed in at any time with no notice period or penalty
- Interest paid gross but is taxable and can be set against a taxpayer’s personal savings allowance
What NS&I products are available to customers with maturing investments?
- Guaranteed growth bonds
- Guaranteed income bonds
- Index-linked and fixed-interest savings
What are the features of a Guaranteed Growth Bond or a Guaranteed Income Bond?
- Fixed terms (1,2,3 or 5 years)
- Minimum renewable amount 5 years
- Interest paid gross but taxable against PSA
- Can be renewed online, by phone or post
What are the two types of NS&I bank account?
- An investment account managed by post only
- A direct saver that can be opened online or over the phone
Who are NS&I savings certificates available to?
Only avail to customers with maturing certificates. They can renew up to total value of maturing certificate inc earned interest.
What is a treasury bill?
- Issued by governments to finance short-term cash needs
- Issued at price less than par value and at maturity, Gov pays full par value
What are the features of a Certificate of Deposit (CD)?
- Issued by banks/building activities to raise funds to finance business activities
- Carry a fixed rate of interest, usually related to LIBOR
- Fixed term to maturity however can be traded
- Receipts of deposit
Who are Treasury Bills managed by?
DMO
What are Treasury Bills used for?
Manage the Government’s daily cash flow needs
How are Treasury Bills issued?
Weekly auctions
How can a member of the public buy a Treasury bill?
Purchase through Treasury Bill Primary Participants and purchase minimum of £500,000 nominal
What are commercial bills?
Short-term negotiable debt instruments issued by companies to fund their day-to-day cash flows
What is a short-term money market fund?
Weighted average maturity < 60 days
Weighted average life < 120 days
What is a standard money market fund?
Weighted average maturity < 6 months
Weighted average life < 12 months
Why are fixed-interest securities issued?
Method of raising money to finance longer term borrowing requirements
What are the general characteristics of a bond?
- Coupon (fixed rate of interest)
- Par value
- Redemption date
What is included in a bond title?
- Issuer’s name
- Coupon
- Maturity date
What are the two types of bond market?
Primary (arranging/selling of original issues)
Secondary (trading)
What is the interest yield on a bond?
Annual income as % of the price investor would have to pay for the bond
What is the formula for interest yield on a bond?
(coupon/clean price) x 100%
What is the difference between interest yield and redemption yield?
Redemption yield takes into account capital gain/loss on redemption
What are the 5 key risks associated with bonds?
- Interest rate
- Liquidity
- Inflation
- Currency
- Default
What happens to bonds as interest rates rise?
Price falls, yields increase
What happens to bonds as interest rates fall?
Price increases, yields decrease
What is the relationship between bond price and interest rates?
Inverse
What are the two types of risk that affect bonds?
- Specific/commercial (particular issuer)
- Market/systematic (general)
How does the coupon affect volatility of a bond?
Lower the coupon, more volatile
How does redemption date affect volatility of a bond?
Longer the period to redemption, more volatile
What are the most volatile bonds?
Lowest coupon, longest period to redemption
What is a normal yield curve?
Demand higher yields for longer period to redemption (rising positive curve)
What is a flat yield curve?
No expected change in interest rates/inflation. Pretty much same price despite period to redemption. (Flat curve)
What is an inverse/reverse yield curve?
Yield on long term bonds is less than short term
What can cause an inverse yield curve?
Investor expectations that interest rates will rise short term, while long term rates fall
Who issues gilts?
DMO
Why does the UK gov issues gilts?
To borrow money when it has insufficient income to meet expenditure
What do index-linked gilts use as the measure of inflation?
before Sep 2005: RPI 8 months before payment
after Sep 2005: RPI 3 months before payment
What happens in a repo 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
What process is stripping?
Separating a conventional interest-bearing gilt into its individual interest (coupon) and redemption ayments, which can be held and traded separately
What are company fixed interest securities referred to as?
Corporate bonds
How do corporate bonds compare with gilts?
- Risk and volatility is larger than gilts
- Spread between buying and selling is wider than for gilts
- Creditworthiness of companies constantly changes compared to governments and so prices can vary despite interest rates and inflation being stable
- Yields on corp bonds higher
What is an unsecured corporate bond?
No asset acting as collateral, creditor ranks amongst ordinary creditors
What is a secured corporate bond?
Charge on certain assets of the issuing company, if the company falls into arrears with interest payments or defaults, assets can be seized and sold.
What is a debenture?
A secured loan agreement between a lender and a borrower with business assets used as security.
What does a debenture agreement include?
- Interest rate, payment dates and redemption date
- Assets backing debenture
- Any conditions imposed by borrower ie maximum amount borrowed/ratios
What is a fixed charge (debenture)?
- Charge over specified asset(s) of the company.
- Typically inc land/property that can be readily identified and should not depreciate.
- Fixed assets cannot be sold without approval.
What is a floating charge (debenture)?
- General charge over any assets of the company that are not otherwise secured.
- Company can freely dispose of floating charge assets but if it defaults, the assets are available to be sold to repay.
- Lower priority than fixed charge
What is a convertible bond?
Unsecured loan stock offering holder option of converting the bond into ordinary shares of the issuing company under specified terms and conditions
What happens to a convertible bond if the conversion does not take place by the expiry date?
Bond will revert to conventional bond
What is a Floating Rate Note (FRN)?
Bonds issued by companies, banks and other financial institutions where the rate of interest is not fixed but instead is linked to a money market rate, such as LIBOR.
How is the coupon changed on a Floating Rate Note?
Reset every quarter to a specified level over the reference rate, ie LIBOR.
What happens to the coupon on a Floating Rate Note if interest rates rise?
Coupon rises
When is a bond cum dividend?
The buyer will receive full six months interest
When is a bond ex dividend?
Interest payments made to whoever is registered owner seven working days before interest payment date
When a bond is cum dividend, what will the buyer pay?
Clean price plus interest that has accrued from the date of the last interest payment
When a bond is ex dividend, what will the buyer pay?
Purchaser will be deprived of interest from the date of purchase to next interest date, and price will be adjusted. Interested is deducted from clean price.
If a company’s credit rating is marked down, what will happen to the market price and yield of its bonds?
Market price will fall and yields will rise
If a company’s credit rating increases, what will happen to the market price and yield of its bonds?
Market price will rise and yields will fall
If the coupon of a bond is above current interest rates and the issuer has a strong credit rating, what will the bond trade as?
Above par
What will happen to an investor if they buy a bond priced above par and they hold it until redemption?
Capital loss
