Cash Risks
-Default Risk Features
Risk of a firm defaulting
1. Creditworthiness of the bank or building soceity
2. Extent to which any compensation scheme will protect the deposits made
-Inflation Risk Features
Purchasing power risk, is the risk that inflation will undermine the real value of cash flows made from an investment.
-Risk of investments losing value due to inflation
- Interest Rate Risk Features
- Reinvestment Risk
Financial Services Compensation Scheme
£85,000 per persons bank account in event of failure of the bank or building society
- Joint accounts can recover the maximum limit of compensation in respect of each other i.e. £170,000
- Deposits held with EEA Branch of a UK firm are no longer protected by FSCS, this includes Outside of EEA, or in the Channel Islands or the isle of man where separate rules apply.
Offshore Bank Accounts
Three common dangers are as follows:
- High rates of interest might seem attractive, but they are usually offered by high inflation countries with potentially collapsing currencies.
- An investor might accept a low interest rate in a strong currency with the expectation that currency gains will always make up for the low return. In fact, strong currencies do not strengthen continuously against sterling: they fluctuate in value like all financial assets. Currencies regarded as strong may not rise enough to compensate for their lower
interest rates. - Some countries do not have the same level of supervisory structure as the UK, meaning
institutional collapse may be more likely.
Types of Bank Accounts
In order of accessibility
- Instant Access
- East Access
- Restricted ( 2 Types)
Notice Accounts
- Notice period between 30 and 120 days are common
- Early access results in interest for the period of notice on account to be withdrawn
Term deposit accounts
- Notice period one to five years
- Fixed Interest
- No/Limited access before maturity
- For investors who want certainty of income
Different types of Deposits Include
Structured deposits
- Interest based on the performance of an equity index (usually ftse100)
Cash ISA’s
- Normal Cash
- Available to individuals aged 16 or older
- £20,000 limit
- Possible to transfer some or all of the money saved in the previous tax years to another ISA.
- Help to buy ISA can be transferred to Lifetime ISA
* **If money is invested to an individual under 18, interest together with any other income from gifts provided by the parent is more than £100 a year, the income will not be tax free and will be treated as parents income until the child turns 18
Eligible Investments can be held in:
- Banks/Building Societies
- Unit trusts and OEICS
- OEIC UK UCITS or a life assurance policy that would return at least 95% of the investors original capital from date of investment
- NSI Direct ISA
- Stakeholder Cash deposits
NS&I
- Direct ISA
- Income Bonds
- Bank Accounts
- Savings Certificates
- Guaranteed Income Bonds / Guaranteed Growth Bonds
- Direct ISA
- Opened online or by phone except Junior which can only be done via online
- Not Flexible - Income Bonds
- Monthly income at a variable rate with no risk to capital
- Must be 16 and over
- Interest paid gross but is taxable, set against personal savings allowance - Bank Accounts
- Investment Managed
- Direct Saver - Savings Certificate
- No longer on sale - Guaranteed Income Bonds / Guaranteed Growth Bonds
- Fixed terms of one, two, three and five years with differing fixed rates
- Minimum renewable amount is £500
- Interest paid gross but is taxable, set against personal savings allowance
- Interest paid once a month - Guaranteed Growth Bonds
Money Markets
Features
- Treasury Bills
- Certificates of deposit
- Commercial Bills
- Very liquid and low risk
- Smooth operation of government finances
- Provide short term capital for companies & Raise funds for short term periods at relatively low interest rates
- Borrowers access funds for fixed period at a fixed rate, Lenders have access instant access
Split into
- Short term money market funds, weighted maturity no more than 60 days and weighted average life no more than 120 days
- Standard money market funds, periods are extended to six and twelve months
Types
- Treasury Bills
- Managed by Debt Management Office
- Issued at a discount
- Manage Governments daily cashflow
- Issued at weekly auctions
- Purchase through treasury bill primary participants and purchase a minimum of £500,000 nominal of bills
- Do not pay interest, instead pays full par value (Interest is equal to the difference between purchase price and maturity value)
- Short terms and highly liquid (1,3,6 or 12 months) - Certificates of deposit
- Receipts from banks for deposits placed with them
- Carry fixed rate of interest related to sterling overnight index average (SONIA))
- Cannot be withdrawn before maturity
- Can be traded on money markets if need access to funds
- Yield on CD’s is less than on a ordinary deposit
- Issued at maturities of one to three months - Commercial Bills
- Short term negotiable debt instruments to fund companies cashflows
- Maturities between 30 - 90 days
- Unsecured and only offered by companies with high credit ratings
- Yield typically higher than treasury bills to reflect higher credit risks and reduced liquidity
Fixed Interest Securities
Characteristics
Bonds
Bond Markets
Bond Indices
Used to raise long term finance by offering directly to capital markets rather than borrowing from banks;
- Banks may not lend for particular term or amount
- Bond market offers wide range of lenders to tap into; London is largest market for international funds
- Bonds are often the cheapest method of borrowing money
Pricing of bonds;
- Cum dividend
- Purchaser will receive the full six months interest even though it was owned by them for less
- Buyer to compensate the seller for the interest
- Buyer will pay clean price plus interest that has accrued - Ex dividend
- If bond is purchased 7 days before interest is due but before payment date, it is bought ex dividend, and full six months interest is paid to seller
- Deducted from clean price
Clean prices ignore value of accrued interest
Dirty price is clean price plus or minus any interest plus
Bond Markets
- Primary Market
- Issued for first time
- DMO issues new gilts weekly - Secondary Market
- Any subsequent trading of bonds
Bond Indices
- FTSE Actuaries UK Gilt Index or Barclays Capital Aggregate Bond Index for Global Bonds
Bond Calculations
Interest Yield
Redemption yield
Interest yield also known as running yield or flat yield or income yield is an expression of annual income from a bond as a percentage of the price the investor paid
*Interest yield = Coupon or nominal price/clean price
Redemption Yield
Takes into account both income payment and capital gain or loss from holding the bond until maturity
*Redemption yield = Interest yield +- ((Gains or loss to maturity/number of years to maturity)/clean price))x100
- If clean price is higher than nominal then loss, vice versa
- Where redemption yield is lower than interest yield, there will be a capital loss if held to redemption
- Ignores tax that you may have to pay
Taxation on Bonds
Capital gains on gilts and most corporate bonds are tax free to investors, income however is taxable on all bonds
Bond Risks
Systematic risk
- Base Rate
- Interest Rates
- Liquidity Risk
- Inflation Risk
- Default Risk
- Base Rate
- Reduction leads leads to increased interest rates in bonds due to higher interest available - Interest Rate
- When IR fall, capital value of bond rises. As the coupon is fixed, the yield adjusts upwards. Vice versa
- Long term bonds tend to fluctuate more often - Liquidity Risk
- May be difficult to sell at an acceptable price - Inflation risk
- Conventional bonds eroded by inflation
- Index linked bonds provide protection because interest and capital are adjusted to inflation
- Price will tend to rise if expectations of inflation diminish and vice versa - Default Risk
- Investment grade bonds have ratings of BBB- or BAA3 or higher
- Non Investment grade bonds have ratings below BBB- or BAA3 and are considered as junk bonds
- If company credit rating is marked down, price will fall, and yield will have to be increased to compensate. Vice versa****
Bond Volatility
- The lower the coupon the more volatile the bond,
- The longer the period to redemption the more volatile the bond
Therefore, holders of high coupons and shorter dated bonds will receive return quicker than lower and longer respectively
rational is greater amount of cash flow from the more volatile bonds is received later in the bonds life and is exposed to interest rates movements for a longer period.
Yield Curves
Comparing yields on bonds
-Relationship between bonds redemption yield and period to redemption
- Normal
- The higher the degree of pessimism over future inflation and interest rates the more steeper the yield curve will rise
- Investors will want to ensure they are getting a high yield to get compensated
- Investors who want income will require more capital to achieve same income in short dated bonds than in longer dated bonds - Flat
- Market is stable and no radical changes to inflation or interest rates
- Prepare to accept lower yield and pay relatively more for longer dated bonds - Inverse
- Yield on longer term bonds is less than on short term bonds
- Caused by interest rate rise in short term, while long term they may be expected that interest rates will be below current levels
- supply and demand also reduce yield on longer dated bonds
GILTS
Adjusted in line with inflation measured by the RPI
Exempt from CGT
Interest received is taxable
Strip Market
Separate trading of registered interest and principal securities
Separating conventional interest bearing gilts into individual coupon and redemption payment. Traded separately in their own right
I.e. 10 Year gilt can be stripped down into 21 parts
- 20 parts on the coupons entitled to just one half yearly interest payment
- 1 part entitled to redemption payment at the end of 10 years
Corporate Bonds
- Secured
- If company falls into arrears with its interest payments, assets can be seized
- Rank before unsecured loans in event company being wound up - Unsecured
- No collateral, and holder will rank for repayment alongside the ordinary creditors of the company
- More expensive to buy and therefore yield will have to be higher
Floating Rate Notes
Issued by companies particularly banks, pay interest that is not fixed but linked to money market rate such as SONIA
Types of Money Market Funds
- Short Term money market funds
- Standard money market funds
- Short Term money market funds
- Weighted average maturity of no more than 60 days and a weighted average life of no more than 120 days - Standard money market funds
- Periods are extended to six and twelve months
