Fixed interest Flashcards
4 elements of fixed interest
fixed
negotiable
long term
debt
3 reasons companies use bonds not banks
period or amount
wider range of lenders
cheaper
Pros and cons of cum dividend versus ex dividend
Cum - provides immediate income from coupon but higher price so capital return might be lower
Ex - lower price so more capital appreciation if IR up, but no income for a while and cant reinvest it if it increase
Howe does DMO auction process work (3)
- Large investors put in bids price/quantity
- Successful bidders pay the price they bid.
- Individuals non-competitive up to £500,000
successful allocated stock at the average of accepted prices.
2 features of cum dividend
comes with 6 months interest
Buyer compensates by paying price + Interest
3 Features of ex dividend
Interest paid to who owns 7 days before interest date
Bond bought after that that date but before interest date then it goes to seller
Amount deducted from clean price
How are corp bonds auctioned (3)
- prospective coupon are marketed to potential investors;
- potential investors place indicative bids
- the final terms are agreed then have 24
hours to make firm bids.
6 factors affect bond pricing
- credit ratings of issuers;
- future interest rate trends;
- changes to expected inflation rates;
- conduct of government finances;
- international tensions and the social and political environment generally; and
- relative attraction of other assets.
5 features of eurobonds
issued in a currency that is different from the currency of the country in which they are issued.
They can be issued by corporations, governments, or supranational organizations.
Traded OTC
Very liquid
Bearer bonds - anoymous
Eurobonds v regular (3 plus 3)
global diversification
potentially higher yields,
tax efficiency
But
currency risk
political/economic risk, r
regulatory complexity.
2 bond indices
FTSE Actuaries UK Gilts Index Series
Bloomberg US Aggregate Bond Index (the Agg)
why might redemption yields be the same but returns different
not include taxation
capital gain free versus income taxed
Investment grade bonds:
These have ratings of BBB– or higher from Standard & Poor’s, or Baa3 from Moody’s.
5 risks of bonds
Credit
Interest rate
Inflation
Liquidity
Exchange rate
Why do bonds trade above/below par?
If the coupon is below
current interest rates, the bond’s price will be below par - vice versa
How do IL bonds work?
Final coupon and capital are uplifted by RPI
what is the indexation lag?
IL bonds are calculated 3 months before redemption RPI
Consideration for investors index linked bond or normal
break-even level of inflation;
rate of inflation that makes yield same as normal
If investor thinks higher might go index linked
IL versus conventional bond (3)
protection against inflation but risk of deflation reducing interest payments and principal/ better in low inflation
less volatile in face of inflation pressures and ir changes/more volatile
lower yield/higher yields
Yields on collective bonds vs direct (5)
Average yields versus specific
diversified versus control
less liquid/more liquid
fees high/low
professional mangement
Non-investment grade bonds
These have ratings below BBB–/Baa3 and are considered to have a significantly
higher risk of default.
change in their creditworthiness (2)
- marked down, price will fall as riskier investments, and investors will require an increased yield
- improved rating will reduce yield -
risk is reduced, and the price will rise.
investment grade v non investment grade bonds (6)
low/high default risk
high liquid/low liquid
low yield/high yield
high IR sensitivity/low
smaller credit spread in good times
capital loss
4 economic factors affecting bond prices
prices tend to rise if expectations of inflation diminish and fall if rate speeding up.
- An increasing balance of payments problem may lead to rising interest rates and
therefore, declining bond values. - Economic growth can fuel inflation, leading to rising interest rates and so declining
bond values. - If an economy is in recession, interest rates may be reduced to stimulate a recovery,
which will boost bond prices.
- the lower the coupon, the more volatile the bond; and
- the longer the period to redemption, the more volatile the bond.
Why?
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.
normal yield curve features (4)
investors demand higher yields for holding longer-term bonds - uncertainty
pessimism over inflation, more
steeply curve will rise as yields needed higher
want to pay less for the fixed return on longerdated
bonds.
investors seeking income, a positive curve means more capital to achieve the same income in short-dated bonds than in longer dated
flat yield curve features (3)
no radical changes to inflation and interest rates are expected
Investors lower yield and pay relatively more for longer-dated bonds.
can buy income at any period for same price, with no penalty for switching from longer-dated to shorter, lower risk bonds.
inverted yield curve features (3)
yield on longer-term bonds is less than on
short-term bonds
interest rates will fall short-term, long-term be substantially below current levels.
It can also be a result of factors connected with supply and demand that reduce yields on longer-dated bonds.
3 yield curve theories
ir rate expectation
liquidity reward
market segmentation
RPI
CPI
CPIH
give a higher inflation figure because it incorporates housing costs like mortgage interest payments and council tax.
broader range of goods and services than RPI but excludes housing costs - harmonised across europe
including all items in CPI plus housing costs related to owning a home, and is now the lead inflation indicator in the UK.
Definition of Repo (3)
sale and repurchase agreement.
one party
agrees to sell gilts to another party with a formal agreement to repurchase
at an agreed price on a specified future date.
5 features of Repo
The price difference between sale and repurchase reflects the interest cost, increasing with the loan term.
While legally a repo involves asset transfer, it often functions as short-term lending using gilts as security.
The interest rate for the loan, secured by gilts, is competitive, allowing the seller to gain gilt market exposure and temporary finance without trading costs.
If the original owner doesn’t repurchase on the agreed date and price, the lender gains ownership and can sell the stock.
The buyback period typically lasts two weeks but can vary from overnight to several months.
4 returns of repos
Interest Income
Low-Risk Return: when the collateral is high-quality, like government bonds.
seller earn returns on the collateral (e.g., interest or dividends on bonds) during the repo period, while also gaining short-term liquidity.
Market Exposure: The seller maintains exposure to the market value of the collateral, benefiting from any potential increase in its value during the repo period.
Features of of Strips (4)
separating gilt into its individual interest (coupon) and redemption payments,
zero coupon instruments, since they pay no regular, half-yearly interest:
investors receive a payment of the strip’s face value when they mature;
*before maturity, they trade at a discount to their face value.
2 strip advantages
Guaranteed Return at Maturity
Can time with other liabilities
Corporate bonds compared with gilts (6)
- The risk attached to corporate bonds is greater
- more volatile than gilts.
- lower quality bonds may be difficult to trade, particularly in a crisis when fewer investors
- The spread between the buying and selling price is wider than for gilts.
- The creditworthiness of companies is constantly changing, unlike that of the Government - even when ir/inf stable
- Yields on corporate bonds are generally higher than gilts,
Explain secured and unsecured corporate bonds (4)
- Secured, charge on certain assets of the issuing company. those assets can be seized on default and sold to repay the loan.
- unsecured, no actual assetas collateral, holder
will rank for repayment alongside ordinary creditors - Secured loans rank for payment before unsecured loans wind up
Yield higher on unsecured/more expensive for borrower
2 restrictions on corporate bond borrowers
- there might be an upper limit on the total amount of money the company could borrow;
- Ratios: max total debt/shareholders’ funds, or company profitability/interest payments.
Definition and features of debenture
secured loan agreement between a lender and a borrower with business assets used as security.
The agreement will include:
* the interest rate, payment dates and redemption date;
* the assets backing the debenture; and
* any conditions imposed on the borrower, such as restrictions
- a fixed charge; or
- a floating charge.
Discuss fixed versus floating charge
Fixed likely land, property etc - cant be sold without permission
cheaper bus restrictive/expensive but secure
Floating
4 features of convertable bonds
Interest is paid as usual until the option is exercised. offer lower coupon rate than loans due to the conversion option i
some offering short conversion periods (e.g., one month in consecutive years) and others specifying a single date.
The number of shares received upon conversion can vary. It may be fixed throughout the conversion period or decrease .
If conversion isn’t completed by the expiry date, the bond reverts to a conventional dated bond,
how does share price affect convertible bonds
a rise in the company’s share price may cause the convertible bond to rise as well
a fall in the share price could mean that the convertible bond is not worth converting, but price not less than bond.
how are convertible bonds taxed
do not qualify for exemption from CGT. Any gains
chargeable to CGT and losses can be set against
conversion v holding (3)
current share price relative to the conversion price,
the potential for future share price appreciation,
time to maturity.
share price higher than the conversion price, conversion might be attractive.
If interest rates rise or the company’s credit rating deteriorates, the bond’s value could decrease, making conversion more appealing.
Benefits and risks of convertible bonds
Benefits: Potential for capital appreciation, downside protection if the bond is held to maturity, and regular interest income.
Risks: Interest rate risk, credit risk, and the possibility of the company underperforming, leading to a lower share price, making conversion unattractive.
Dilution of Equity convertible bonds
when additional shares are issued, reducing the ownership percentage of existing shareholders.
When convertible bonds are converted into shares, new shares are created, which can dilute EPS and potentially reduce the share price.
This could negatively impact existing shareholders if the conversion leads to a significant increase in the number of outstanding shares.
define conversion premium
the difference between
the market price of the convertible bond and
its conversion value,
expressed as a percentage of the conversion value.
what are floating rate notes
bonds with IR not fixed
MM rate eg Sonia
If IR rate rises coupon rises
why is FRN likely to stay close to nominal value
it is the interest rate on the FRN itself that will change not price
Price can still alter if creditworthiness changes
3 key differences FRN traditional bond
The coupon payments of an FRN vary with changes in the benchmark interest rate, making FRNs less sensitive to interest rate changes
In an FRN, the coupon rate is reset at regular intervals (e.g., every 3 months), based on the current level of the benchmark rate plus a fixed margin. In contrast, a fixed-rate bond pays a predetermined, constant interest rate throughout its life.
Because FRN coupons adjust with market interest rates, the market value of an FRN tends to be more stable, whereas the price of a fixed-rate bond typically falls when interest rates rise and rises when interest rates fall.
Benefits of FRN in a rising interest rate environment
Benefits:
Interest Rate Protection: One of the main benefits of FRNs is their ability to provide a hedge against rising interest rates. Since the coupon rate adjusts with changes in the benchmark rate, investors can potentially benefit from higher income in a rising rate environment, unlike fixed-rate bonds, which would lose value as rates rise.
Lower Duration Risk: FRNs generally have a lower duration compared to fixed-rate bonds, meaning they are less sensitive to interest rate movements. This can be particularly advantageous in a portfolio where interest rate risk is a concern.
Income Diversification: Adding FRNs to a fixed-income portfolio can enhance diversification by introducing a security that behaves differently from fixed-rate bonds, especially during periods of rate volatility.
risks of FRN in a rising interest rate environment
Coupon Payment Uncertainty: The variable nature of FRN coupons means that income from these securities is uncertain. If the benchmark rate falls, so will the coupon payments, potentially resulting in lower-than-expected income for the investor.
Credit Risk: Like all bonds, FRNs carry the risk that the issuer may default on payments. The creditworthiness of the issuer should be carefully considered, especially since FRNs do not offer a premium yield over fixed-rate bonds with similar credit risk.
Liquidity Risk: Depending on the market and the specific FRN issue, these securities may not be as liquid as more commonly traded fixed-rate bonds. This could make it more difficult to sell an FRN without impacting its price.
Define PIBS 3
PIBS are fixed-income securities issued by UK building societies.
They are perpetual, with no fixed redemption date.
No new issues but existing can be traded
4 Key Differences from Conventional Fixed-Income Securities:
Perpetual Nature: Unlike bonds, PIBS have no maturity date; they may be held indefinitely.
Income Payments: Pay fixed interest (coupon) but can be deferred by the issuer, unlike regular bonds where interest payments are obligatory.
Capital Security: PIBS are subordinated debt, ranking below senior debt in the event of liquidation, making them riskier than conventional bonds.
Liquidity and Trading: Traded on the London Stock Exchange, but usually less liquid and more volatile than conventional bonds.
3 risks 4 benefits of PIBS
Benefits:
High Yield: Typically offers a higher coupon rate compared to other fixed-income securities due to its higher risk.
Income Potential: Provides regular income, assuming the issuer continues payments.
Portfolio Diversification: Adds diversification to a portfolio, with different risk/return characteristics compared to bonds.
Risks:
Income Stability: Payments can be deferred or canceled if the issuer faces financial difficulties, leading to uncertain income.
Capital Security: Subordinated debt status means lower priority in liquidation, increasing the risk of capital loss.
Price Volatility: Prices can be volatile due to the perpetual nature and lower liquidity.
No Maturity Date: Investors may never get back the principal unless the issuer opts to redeem the shares.
4 risks of debentures for cos
Fixed Financial Obligation (2 marks):
Asset Encumbrance (2 marks):
Potential Credit Rating Impact (2 marks):
Risk of Default (1 mark): If the company faces financial difficulties, there is a risk of default, leading to insolvency.
