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UK Financial Services, regulations and ethics Demo

2.2 Asset classes - fixed interest securities

In this section, we aim to understand the main features, types of potential returns, key factors affecting price, volatility, access, taxation issues and variations of fixed interest securities as an investment asset class.

Fixed Interest Securities are loans that are issued by companies, governments and other bodies such as local authorities. Many types of these securities are now available on the open market to suit different types of needs and risk profiles

They have several common features. In the main, these securities are tradable in that once an investor buys a bond (by doing so he lends money to the borrowing institution), he can then go onto sell it to a third party prior to redemption. This can be done several times before the term of the security ends

In general fixed interest securities will carry a fixed coupon or rate of interest. Typically, interest will be paid every 6 months. Some stocks e.g. index linked gilts, offer a coupon and capital value at redemption that increases with the RPI

To assess the interest (running/income) yield received from a bond for the...

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...t for tax. The formula is:

Net interest yield + (gross redemption yield – gross interest yield)

Using our example above, we can analyse the effect of taxation on the overall yield:

The gross interest yield (running yield) is 4.5%. Gross redemption yield is 2.35%

 

Starting rate taxpayer (10%)

Basic rate taxpayer (20%)

Higher rate taxpayer (40%)

Gross interest yield

4.50

4.50

4.50

Less tax

0.45

0.90

1.80

Net interest yield

4.05

3.60

2.70

Loss/Gain to redemption

-2.15

-2.15

-2.15

Net redemption yield

1.90

1.45

0.55

Low coupon stocks will provide less taxable income and smaller gains and losses on redemption than a high coupon stock. They could therefore be attractive to higher rate taxpayers. Higher coupon stocks will be more attractive to starting rate or non taxpayers.

As the income from a bond remains constant throughout its life (with the exception of ind...

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...ore make capital gains or losses which on the majority of these investments, is tax free.

Non systematic risk

In the case of fixed interest securities, we would need to consider factors that could affect an institution’s ability to repay capital and/or income. The risks of this happening can be categorised under the headings of non-systematic risk (the risk arising from factors affecting the individual institution) and systematic risk (the risk arising from factors affecting the market as a whole)

Under non-systematic r...

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...rn quicker than a similarly dated low coupon where the majority of return is tied up until the final payment at the bond’s maturity

The holder of a shorter dated bond will get a return on the bond earlier than a holder of a longer dated stock and will be exposed to interest rate movements over a shorter period of time

Therefore, the stocks that tend to be most volatile in price movements are longer dated stocks with lower coupons.

Government bonds and fixe...

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...sed on supply and demand.

Interest received subject to income tax in the year received at the rates for interest – 1...

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...e, capital gains will always be tax free as well as the interest received.

* where applicable.

Gilts are categorised in relation to their redemption periods. “Shorts” have less than 7 years to redemption. Favoured as surplus deposits by larger financial institutions. Classified by the Financial Times as having less than 5 years to redemption

Mediums are from 7 – 15 years. Too long in term to be of interest to banks as a means of holding excess liquidity and too short to be of interest to pension funds. They are often the least popular gilts. The F...

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...ents

A repo sale is one where the seller simultaneously agrees to repurchase the stock being sold on a stipulated date at an agreed price which guarantees the buyer a small profit

This is effectively a loan taken out by the original seller using the gilt as security

If the original owner does not buy back their stock on the set date at the agreed price, the gilt will become the property of the new owner and he will be within his rights to sell it on the open market.

These serve the same purpose as gilts. However, the buying and selling prices (bid/offer spreads) are wider than gilts to account for the higher risk

The markets are less liquid i.e. less buyers and sellers

Creditworthiness of institutions is forever being updated

Yields are generally higher than gilts to compensate for the extra risks.

Categories of Corporate Bonds

Debentures

Usually implies that the debt is covered by some form of security and conditions may be imposed on the borrower to maintain the importance of the debt in relation to others. It will often stipulate the debenture holder’s priority over other company creditors

Some debentures will be “secured” against assets within the company. These could be fixed i.e. specific assets, or there could be a floating charge over any of the company’s assets...

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...ore if they are missed there is no obligation to make the payments up

High minimum investment limits. The market is quite illiquid

Higher yields provided than gilts due top less security of repayment

Interest paid half yearly gross but is taxable

Fall within qualifying corporate bond regime for CGT purposes

If the building society converts to a bank, PIBs become Perpetually Subordinated Bonds.

Eurobonds

This is the UK market for bonds denominated in other currencies

Issued in fixed or floating rate note form

Eurobond market is free form governmental control so many innovative products devised e.g. bonds paying interest in dual currencies, bonds issued with warrants etc

Interest is paid gross without deduction of tax.

Bulldog bonds

These are loans raised in Sterling by overseas governments on the London Stock Exchange.

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