Section Two: Fixed Interest Securities

Question 1

What are fixed interest securities?

Answer 1

They are a mechanism by which large companies, institutions and governments raise capital.

Generally considered long term (2-30 years)

They promise to pay a rate of return in exchange for investors cash - essentially a loan.

Question 2

All fixed interest securities, bonds will generally share the same characteristics - which are (x3)

Answer 2

• fixed redemption value known as the par value.
• repaid after a set period had elapsed
• carry a set interest rate known as the coupon

Question 3

What is the coupon (return) based on?

Answer 3

The nominal (original) value - not what it was potentially sold on second hand for.

Question 4

What are the risks associated with fixed interest? And what do they mean?

Answer 4

• There is an inverse relationship between the prices of bonds and interest rates. Meaning prices/demand rises and falls depending on what interest rates are doing.
• liquidity risk : risk that the investor may not be able to sell the bond.
• currency risk : exchange rates etc
• default risk : that the issuer may not be able to pay back capital or interest
• inflation and future inflation : where the market expects inflation to rise, the likely effect is a fall in bond prices.

Question 5

What are the two categories of risk associated with fixed interest securities and what do they mean?

Answer 5

Commercial / Specific - risk for that individual issuer

Market / Systematic - risk for the fixed interest asset class as a whole

Question 6

Which bonds are most volatile? And why?

Answer 6

• Bonds with lower coupons
  and
• Bonds with longer redemption periods (maturity dates)

Because they’re exposed to interest rate movements for a shorter period of time.

Question 7

Name, three types of fixed interest securities

Answer 7

• Gilts
• Corporate bonds
• Permanent, interest-bearing shares (PIBS) and perpetual subordinated bonds (PBS)

Question 8

What are gilts?

Answer 8

Gilts or gilt-edged securities are loans to the government offering either a fixed or index linked coupon.

They are classified according to the period of redemption.

Question 9

How long is a short gilt?

Answer 9

Less than seven years, according to the government debt, management, office or less than five years, according to the financial press.

Question 10

How long are medium gilts?

Answer 10

Between 7 and 15 years, (DMO)

5 and 15 (press)

Question 11

How long are long gilts?

Answer 11

15+ years

Question 12

What is the difference between a standard gilt and a index-linked gilt?

Answer 12

As far as I’m aware… they work the same except…

A standard guilt has a fixed coupon - so a set rate of interest -

An index linked gilt has a coupon that fluctuates in line with inflation measured by RPI.

Question 13

If a gilt was issued before September 2005, when is the value of RPI taken prior to each payment date?

Answer 13

8 months prior to each payment date

Question 14

If a gilt was issued after September 2005, then when is the value of RPI taken prior to each payment date?

Answer 14

3 months prior to each payment date

Question 15

What are the benefits and drawbacks to opting for a gilt that links payments to inflation?

Answer 15

It’s a way of protecting your income/investment from the damage and effects of inflation.

However, this also means that the coupon and yields on index linked bonds are lower than those of conventional ones.

It’s also necessary to understand that it’s possible to have both interest and capital payments fall if RPI falls .

Question 16

What is the tax position for gilts? CGT and income tax.

Answer 16

Disposal proceeds are free from CGT

However, income is fully taxable income tax.

Question 17

What is the buy back period associated with gilts and what does it range from? (REPO)

Answer 17

Where an institution (borrower) sells a gilt/s and agrees to buy it to slash them back with interest.

The buyback period ranges from 24 hours, two months, however, a typical period is two weeks.

This essentially turns the transaction into a secured loan, with the gilt/s used as collateral.

Question 18

Who is the borrower and who is the lender when selling gilts to raise capital? (REPO)

Answer 18

• The institution is the borrower as they are essentially looking to raise cash by borrowing the funds, using the gilt as collateral.
• The lender is the investor as they are lending their cash to the institution/borrower again, using the gilt as collateral.

Question 19

What is a risk associated with a REPO for the lender?

Answer 19

The risk to the lender could be that the gilt loses value, and as such if the borrower can’t repay, i.e buy back the guilt, plus interest at the specified date, the lender will be left with an asset that is worth less than the original amount.

Question 20

What is the repo rate?

Answer 20

It is essentially the difference between the amount paid for the gilt to the borrow at the repo start date and the amount the borrower pays back to the lender at the repo end date.

The repo rate is essentially the interest rate on the loan.

Question 21

Why does the bank of England use the REPO market?

Answer 21

To help set interest rates

Question 22

What does strips stand for?

Answer 22

Separate Trading of Registered Interest and Principal Securities

Question 23

What is the strips market?

Answer 23

It is where the guilt is separated into its coupon, and it’s redemption value and eat your soul/traded separately.

For example, the investor requiring an income could buy the coupon, whereas someone requiring a lump sum at future date by the capital redemption for a discounted rate.

Question 24

How often are coupon payments made?

Answer 24

Half yearly / six months

Question 25

How could a 20 year guilt be divided?

Answer 25

Into 41 separate elements

40 coupon payments (2 per year)
1 capital redemption

Question 26

Do strips pay interest?

Answer 26

Strips to not pay interest (known as zero-coupon)

An investor will receive the face value on maturity. Prior to maturity, they would trade a discount to face value.

Question 27

The value of the strip will fluctuate in depend on a number of factors, such as…

Answer 27

Inflation, prevailing interest, rates and economic conditions at the time.

Question 28

Give three reasons why a company may choose to issue corporate bonds as an alternative to taking a loan with the bank

Answer 28

• It’s comparatively cheaper
• Gives access to a range of land markets
• It may not be possible to secure a bank loan over a long enough term for the business needs

Question 29

What is the term bond referring to? Or AKA

Answer 29

Fixed Interest Security

Question 30

What is a fixed interest security?

Answer 30

Fixed-interest securities are issued by governments, companies and other official bodies as a method of raising money to finance their longer-term borrowing requirements.

In return for lending money to these institutions, the owner of the fixed-interest security is entitled to receive regular interest payments and usually a repayment of their capital at the end of a pre-determined period.

They cannot be cashed in before their official maturity date; however, investors can sell them on the stock market at any time without needing to refer to the original borrower.

Question 31

What are fixed interest, securities also known as?

Answer 31

Fixed-interest securities are also known as bonds, loan stock, debentures and loan notes.

Other names, such as gilts and corporate bonds, signify loans to particular types of borrowers: securities issued by the UK Government are called ‘gilts’ or ‘gilt-edged securities’, and securities issued by companies are known as ‘corporate bonds’.

We use the term ‘bond’ to refer to fixed-interest securities.

Question 32

What are the three characteristics of a bond?

Answer 32

Bonds have certain common characteristics. They generally:

• carry a fixed rate of interest, known as the coupon;

• have a fixed redemption value, known as the par value; and

• are repaid after a fixed period, at the redemption date.

Question 33

The title of a bond will always have three things which are…

Answer 33

The title of a bond will always give three key features:
1. issuer’s name;
2. coupon; and
3. maturity date.

Question 34

What is a debenture?

What will a debenture agreement include?

Answer 34

A debenture is a 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 restricting the total amount of money the company can borrow by imposing a maximum ratio of debt to share capital.

Question 35

Debentures can be secured by what?

Answer 35

A fixed or a floating charge

Question 36

In relation to debentures, what is a fixed charge? And what is a floating charge? Who takes priority if a company defaults?

Answer 36

Fixed charge

• A fixed charge is a charge over a specified asset or assets of the company:

– These typically include land or freehold property that can be readily identified and should not depreciate in value over the term of the loan.

– The fixed-charge assets cannot be sold by the company without the consent of the debenture holder.

Floating Charge

• A floating charge is a general charge over any of the assets of the company that are not otherwise secured in favour of other lenders or banks:

– The company can freely dispose of floating charge assets in the usual course of its business but, if it defaults on the loan, the assets are available to be sold to repay the debenture holder.

– A debenture with a floating charge has a lower priority for payment than a debenture with a fixed charge if the company is wound up.

Question 37

What is a convertible bond?

Answer 37

The option to convert the bond to ordinary shares in the company, on the conversion date in the future and reap the rewards of a favourable share price.

They trade at a premium to the shares that they can be converted into.

If a conversion doesn’t happen it will usually revert back to a standard corporate bond with an option for the company to redeem any outstanding stock.

Question 38

What are the pros & cons of a company offering an asset as collateral (secured loan)?

Answer 38

There is no obligation for a company to provide security for a loan; however, an unsecured loan will usually be more expensive for the issuing company than a secured loan. The yield will have to be higher to attract investors.

Question 39

Are convertible bonds subject to CGT?

Answer 39

Bonds that can be converted into shares do not qualify for exemption from CGT. Any gains on disposals are chargeable to CGT and losses can be set against other taxable gains.

Question 40

What are the characteristics of convertible bonds?

Answer 40

• Interest is payable in the usual way until the option is exercised, although they usually carry a lower coupon than straightforward loans because of the right of conversion into ordinary shares at some future date. The low interest rate is compensated for by the opportunity of a favourable return on conversion.

• Conversion rights can vary considerably between different convertible bonds. Some have a short conversion period, such as one month, in each of a number of consecutive years, while others have a specified date on which the conversion option may be exercised.

• The number of shares the holder will receive may also differ between issues. The number may be fixed throughout the entire conversion period, or may reduce towards the end of the period.

• If the conversion does not take place by the expiry date, the bond will revert to a conventional dated bond, although the company usually retains a right to redeem any stock outstanding once a certain percentage has been converted.

Question 41

What is a FRN?

Answer 41

Floating-rate notes ready steady yes are bonds issued by companies, particularly banks and other financial institutions including governments, which pay a rate of interest that is not fixed but instead linked to a money market rate, such as SONIA.

The coupon is reset every quarter to a specified level over the reference rate, e.g. SONIA. If interest rates rise, the FRN coupon also rises.

The interest rate may be set by reference to the average of SONIA over a six-month period and expressed as basis points (hundredths of one percentage point) above SONIA, e.g. ‘SONIA plus 50 basis points’ would be an additional 0.5%.

• The coupon is usually paid half-yearly or quarterly and the rate for each coupon is determined at the beginning of each coupon period

Question 42

What are PIBS?

Answer 42

Permanent interest-bearing shares and perpetual subordinated bonds
Permanent interest-bearing shares (PIBS) were a type of fixed-interest investment issued by building societies, listed and traded on the stock exchange. Perpetual subordinated bonds (PSBs) were originally issued as PIBS by building societies that then went on to convert to banks.
Neither PIBS nor PSBs can now be issued as they no longer meet regulatory requirements; however existing holdings can still be traded on the stock exchange.

Question 43

When trading in an open market affix interest, security Holden will be referred to by reference to the what?

Answer 43

Nominal value, not the price paid

Question 44

What is meant when it says that Bond has been traded at par?

Answer 44

It is being traded at its nominal value. Where is all the above par is being sold for more than the nominal value and below par for less.

Question 45

Where are prices for bonds quoted and why are they not ideal?

Answer 45

Prices for bonds quoted online and in major newspapers. These don’t tell a full picture though, as they only quote the mid market prices (between the buying and selling price) and ignore the effects of any accrued interest. (they are known as a clean price.)

Accrued interest on a bond is important as it builds up between payment dates and his added, or taken away from the clean price to get the true price of the Bond.

Question 46

Define mid-market prices in relation to fixed interest securities (bonds)

Answer 46

They are mid-market prices, i.e. the mid-point between the buying and selling prices quoted in the market. An investor would pay a higher price to purchase a bond, and receive a lower price on a sale

Question 47

Explain clean prices…

Answer 47

They are clean prices and ignore the value of accrued interest, which is the interest that builds up between interest dates.

The interest on bonds is calculated daily and must be added to or subtracted from the clean price to arrive at the total purchase price of
the bond.

Question 48

How often is interest accrued on bonds?

Answer 48

Daily but paid every six months

Question 49

Explain cum dividend…

Answer 49

• When a bond is cum (with) dividend, the purchaser will receive the full six months’ interest, even though the bond was owned by them for less than the entire period.

• Consequently, when the bond is purchased, the buyer has to compensate the seller for the interest to which they were entitled but did not receive.

• The buyer will pay the clean price plus the interest that has accrued from the date of the last interest payment up to the settlement date (usually the business day after purchase).

Question 50

Explain Ex dividend….

Answer 50

• Interest payments are usually made to whoever is the registered holder of the bond seven working days before the interest payment date.

• If the bond is purchased after that time but before the payment date, it is bought ex (without) dividend, and the full six months’ interest will be paid to the seller.

• Anyone buying the bond after it goes ex dividend is deprived of interest from the date of purchase to the interest payment date, and the price is adjusted to reflect this.

• Interest in respect of the period for which the buyer owned the bond, but which was paid to the seller, is deducted from the clean price.

Question 51

The actual price paid by the purchaser is known as the ? Price…

Answer 51

Dirty Price.

Prices are said to be quoted clean and settled dirty .