Cash and fixed interest securities Flashcards
(35 cards)
What are the different types of risk?
Currency Risk
Interest Rate
Liquidity Risk
Counterparty
Regulatory
Income
Inflation
Shortfall Risk
Systematic and non-systematic risk
What are the general characteristics of cash deposits?
- Investors receive regular interest on the deposit
- Investor’s capital is not exposed to investment risk
- The return is just interest income with no capital growth
- Assets are liquid
some accounts which offer higher interest rates may impose penalties on withdrawals or have notice periods. penalties are:-
- loss of interest differentials (i.e. the rate drops to the standard)
- loss of interest for the period of notice required
- for NS&I products no interest at all if surrendered in 1st year.
What risks are associated with cash?
Default Risk
Inflation Risk
Interest Rate Risk
Currency Risk
What considerations should you have to judge the level of default risk?
Creditworthiness of bank.
i.e. look at it’s credit rating with Standard & Poor.
Compensation scheme
Is the bank a member of FSCS? Remember that if accounts are held in subsidiaries of a larger group and only the parent is authorised then the first £85,000 overall is protected.
Also only covers EEA and not Channel Islands or Isle of Man.
What considerations should you have to judge the level of inflation risk and interest rate risk?
Inflation Risk
Long term investors may find that the final sum paid our including interest will purchase less than the original sum would have done when invested.
Interest Rate Risk
A variable interest rate account is dependant on the base rate. Even fixed term deposits are vulnerable if rates fall at time of maturity so they cannot reinvest at the same level.
What considerations should you have to judge the level of currency risk?
- High interest rates means high inflation in the country which could collapse.
- Currency rates fluctuate so are no guarantee of return
- Many countries don’t have the same supervisory structures as UK.
Consider
- what the market thinks will happen ove rthe lifetime of the investment?
- the currencies past volatility against major currencies
- If the investment is at a variable rate don’t forget to consider interest rates
- Will the bank have the funds to pay out on maturity?
- Is there any compensation scheme and what limits does it have?
What is a structured deposit account?
An account that pays interest based on the performance of an equity index (usually FTSE 100). Typically provides a return over a fixed term which isthe greater of:-
- the original investment
- a multiple (e.g. 100%) of the change in the FTSE 100
Usually require being tied in for 5 years so inflation risk
an example is NS&I Guaranteed Equity Bond.
Different from other <strong>structured products</strong> as the deposit taking firm has the obligation to repay the depositor rather than where a wrapper offers a structured product and so the <strong>default risk</strong> is with the third party that issues the debt securities not the company offering the wrap.
What are offshore sterling deposit accounts?
Generally available from UK branches of banks & building socities situated in tax havens such as Channel Islands or Isle of Man. Various types of accounts which usually pay interest at a rate higher than UK equivalent accounts and pay gross.
Cash Isas
- £5,760 for 13/14
- previous years investment can be transferred in part or whole
- current tax year’s investment must be transferred in whole
- cash can be transferred to another cash or stocks & shares ISA
- If transferred to Stocks & shares it is treated as though invested directly in stocks & shares and as if the Cash ISA subscription had never existed
- you cannot transfer cash from Stocks & Shares ISA to cash ISA
Eligible investment include
- OEICS
- Unit Trusts
- stakeholder cash deposit products
- Non qualifying life assurance policy
- Undertakings for Collective Investments in Transferable Securities (UCITS)
What are Money Market Investments?
Money Markets are where banks etc lend and borrow from each other. It plays an essential role in government finances and the banking industry and provides short term capital from companies.
They allow issuers to raise funds for short term (fixed) periods at relatively low interest rates (also fixed).
Lenders can sell the security in the money market at any time so provides them with instant access.
Are Money Market Investment Vehicles suitable for your client?
Direct investment from individuals is unlikely due to amounts required. Funds are created to pool together all investors’ funds. Some funds are just cash but others are more complicated.
Consider:-
How do returns compare with other cash based investments?
What are the charges and how do they impact returns?
How long will it take to realise an asset if neccessary?
What are the underlying assets and what risk is the fund exposed to?
How experienced is the fund management team?
Types of Money Market Instruments
- Treasury Bills
- Certificates of Deposit
- Commercial Bills
What are Treasury Bills?
- Issued by Debt Management Office of HM Treasury to finance short term cash needs via weekly auction.
- Have maturities of 1, 3 or 6 months
- Can be bought by the public (Min £500,000)
- Don’t pay interest. Issued below par and par value paid at maturity.
- Risk Free and used as benchmark “risk free rate of return” when measuring the risk premium of other financial instruments
What are Certificates of Deposit?
- Receipts from banks for deposits placed with them
- Fixed rate of interest. Yield depends on market rates and credit rating of the bank.
- Fixed Term (usually 1-3 months) and cannot be withdrawn early
- Lower yields than on ordinary deposits as they can be traded so easier access to capital.
What are Commerical Bills?
- Short term negotiable debt instruments from companies. Used to fund day to day cashflow.
- Issued at discount to maturity value (similar to Treasury Bills).
- unsecured so usually on from companies with high credit rating
- higher yield than Treasury Bill as more risk and less liquidity.
What are Fixed Interest Securities?
Issued by Government or companies to finance longer term borrowing requirements. Known as stock,loan stock,debentures,securities, loan notes. Gilts and corporate bonds signify loans to particular types of borrowers.
They pay out regular interest payments and return capital on maturity.
Negotiable: after buying the security the lender can sell the entitlement to interest and capital to 3rd party who can also sell.
Fixed interest: Borrower committed to pay interest at fixed rate for duration
Long term: typically 2 - 30 years
Debt instrument: they represent borrowing
Characteristics of Fixed interest securities
Bond Title
- issuer’s name
- coupon. (i.e. fixed interest rate usually paid out every 6 months)
- maturity date (when nominal value repaid to whomever holds the bond at that time). Two dates means the borrower can chose, giving at least 3 months notice.
Pricing & Trading Fixed Interest Securites
Bonds are traded by par value. Prices are quoted per £100 nominal value of stock although any amount can be purchased.
Interest usually paid twice a year to whomever holds the stock 7 working days before interest payment date.
With (cum) dividend
Purchaser receives full 6 months interest even though they didn’t hold the stock for the whole time.
Cost = Clean price plus interest accrued
Without (ex) dividend
Seller keeps dividend if sold between before dividend payment but after qualifying date.
Cost = clean price minus interest accruing from sale.
Clean price +/- interest = dirty price!
Bond Markets - Primary Market
Debt Management Office auctions gilts weekly.
- Large investors bid at price & quantity they want
- Successful bidders pay the price they wanted
- Individuals bid up to £500,000 and are allocated stock at the average of accepted prices.
Companies issue less frequently and market them to potential investors. Investors place indicative bids at a certain price and once terms agreed they have 24 hours to finalise the bid.
Bond Markets - Secondary Market
Government sector
Uk Government is biggest borrower in UK bond market
Corporate Sector
Sterling loans to foreign borrowers
Eurobond market
Eurobond is an international bond in a currency other than that of the country it is issued. (e.g. British Company issues Eurobond in USA in Yen). Bond named according to currency it is issued in ($US = Eurodollar bond). Used by World Bank
Bond Yields - Interest Yield
Annual income as a % of price
Can mislead as bond may provide a capital gain or loss at redemption
coupon/clean price X 100
Redemption Yield
More accurate.
_Gain(or loss) to maturity ÷ years to maturity _
Clean price x 100
If Redemption Yield is less than Investment Yield there will be a capital loss at redemption. Remember interest is taxable but capital is not so you can have two similar redemption yields with different net benefits to the individual
Risks
Interest Rate risk
a rise in interest rates means a fall in capital value.
Liquidity Risk
Inflation Risk
Currency Risk
Default risk
Market or systematic risk if expectations of inflation diminish the bond prices go up and they fall if rate of inflation is deemed to be speeding up
Volatility of Bonds
The lower the coupon the more volatile the bond.
The longer till redemption the more volatile the bond.
this is because a high coupon means you get a return for your investment more quickly than with a low coupon (where you are more reliant on maturity).
A shorter bond doesn’t have the benefit of time to recover from fluctuations in the market.
