Investment Risk and Tax Planning: Understanding Bonds and Interest Rates, Exams of Business Taxation and Tax Management

Download Investment Risk and Tax Planning: Understanding Bonds and Interest Rates and more Exams Business Taxation and Tax Management in PDF only on Docsity! CISI Investment Risk and Tax Planning - Chapter 1 Exam (100% Correct Elaborations) Why should you hold cash? - Liquity (instant access) for planned spending or emergency funds - Safe since capital is unlikely to be lost since there is no captial gains and interest is paid so you get real return What is the interest rate ? Interest is a percentage of funds deposited - higher the deposit , higher the rate Types of interest rates? Fixed or Variable interest rates Difference between Gross and Net Interest Gross is interest that is paid before the deduction of income tax or other charges are deducted. Net interest rate is effective interest rate after tax is deducted from the gross rate. What is the Annual Equivalent rate? The AER makes it easier to compare savings accounts in the UK by illustrating how much interest you could earn from a savings account if it were open for one year. (It is usually quoted gross) What is compound interest? The interest you earn from a savings account could be paid to you as you earn it or at a later date, or it could be paid back into your savings account, from which you could earn interest from your original deposit, as well as on any interest you've earned. This process is known as compounding. Features of National Savings and Investment Products - Only risk free deposits since it's government backed - It's an agency of the chancellor, accountable to the Treasury. What is peer to peer lending? - Lending to individuals without using a financial intermediary (ie. bank) - It brings borrowers and lenders together online in return for a fee. What are the disadvantages of peer to peer lending? - Default on loans by the borrowers (ie. unable to pay it back) - EXTRA: Loans are sometimes pooled to diversify risk. -There is high APR on peer to peer lending compared to getting loans from a bank > Longs- over 15 years to run What are the types of gilts? Index Linked Gilts (linkers) - both the interest rate and the capital redemption on these gilts is calculated by reference to the inflation rate (based on CPI), as measured at a set point before the pay date. Convertible Gilts - The owner has the right to convert the gilt into predefined amounts of a different gilt at some time in the future. Floating rate gilts - they pay variable coupons every three months. The coupon is set by reference to LIBID at the beginning of each interest payment period. They tend to trade at around par (nominal) value. How are gilts classified? There are two ways gilts are classified. The first way is the Financial Times Method which classifies gilts as : - shorts: under 5 years to redemption -mediums: 5-15 years to redemption - longs: over 15 years to redemption The second way is the market convention ( used between gilt dealers on the LSE) which classifies gilts as: - shorts: 1-7 years to run to redemption - mediums: 8-15 years to redemption -longs: over 15 years to run What are zero coupon bonds? - Pays no interest, issued at a discount at a price below its eventual redemption price(redeemed at par) - E.g. issued at £60 per £100 nominal -Taxed as though income is paid - no Capital gains tax on the gain What are Treasury Bills? - Issued by the UK Government via the Debt Management Office (DMO) - Function in a similar way to zero-coupon bonds - T- Bills can be issued with maturities of 1 month ( 1 month tender) , three months, six months - If you want to purchase T-Bills at the tenders you must do so through one of the treasury bill primary participants ans purchase a minimum of £500,000 nominal of bills. How are foreign government bonds issued internationally? - Central bank for the countries US, Germany, France - Ministry of finance for the countries Netherlands, Japan - Government agency (DMO) for the countries UK, Ireland, Sweden, Portugal, New Zealand What are the features of foreign government bonds? - Issuance could be via specialist dealers or to syndicates of banks - Bonds may be bearer (anonymous) or registered • Coupons can be Semi-annual - UK, US, Italy, Japan Annual - France, Germany, Netherlands, Spain, Belgium What are the examples of government bonds? • T-bonds - the name given to bonds with a maturity of ten years or more, issued by the US and Canadian governments. • T-notes - as for T-bonds, but with a maturity of between two and ten years. • Bunds - issued by the German government, with a maturity of anything up to 30 years. • OATs (Obligations Assimilables du Trésor) - issued by the French government, with a maturity from two to 50 years. BONOs (Bonos del Estado) - issued by the Spanish government, may have almost any maturity period. What are local authority bonds? These are loan stocks issued by the UK Local Authorities What are the features of local authority bonds? -Interest is paid to investors net of basic rate tax - Usually secured by a charge over the assets of the issuing authority - May also be guaranteed by the Public Works Loans Board - They are irredeemable ( there is no redemption date). The only time they will be repaid by building society is on liquidation. - No FSCS protection for PIBS/ PSB holders - If a building society demutualises ( complex process of transitioning a company's financial structure), PIBS convert to perpetual subordinated bonds (PSBs) What are convertible bonds (convertible loan stock) ? A convertible bond is a fixed-interest corporate bond that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder. What are Contingent convertible bonds (or CoCos)? Contingent convertibles (CoCos) are a debt instrument issued by European financial institutions. Contingent convertibles work in a fashion similar to traditional convertible bonds. However, conversion to equity or stock is contingent on a specified event occuring. E.g: They have a specific strike price that once breached, can convert the bond into equity or stock What are Supranational bonds? - issued by supranationals such as the European International Bank and the World Bank. Considered very safe What are Asset-backed securities? - These are bonds issued on the security of a stream of specific income flows, such as cash flows from mortgage repayments. What are High Yield Bonds? High-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds ( credit rating of below BBB -) . High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors. What are guaranteed bonds? - guaranteed bond is a debt security which promises that, should the issuer default, its interest and principal payments will be made by a third party ( such as financial institutions, funds, governments, or corporate subsidiaries) . What are floating rate notes? This is a form of security that carries a variable interest rate which is adjusted regularly( 1- 6 months intervals) by a margin against a benchmark rate, such as LIBOR. - They are attractive in times of volatile interest rates when lenders may be reluctant to lend funds cheaply. What are the risk of bonds? - Credit Risk: This is the risk that an issuer will be unable to make interest or principal payments when they are due, and therefore default. Bonds with a lower investment grade are more likely to default and interest payments are unlikely to be paid. - Economic Environment Changes: These can be changes to GDP or unemployment pressures. - Liquidity Risk: This is the risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. To minimise this risk, investors may wish to opt for bonds that are part of a large issue size and also most recently issued. - Inflation Risk:This is the risk that the return you earn on your investment doesn't keep pace with inflation. If you hold a bond paying 2% interest and inflation reaches 3%, your return is actually negative (-1%), when adjusted for inflation. You'll still get your principal (coupon) back when your bond matures, but it will be worth less in today's dollars. Inflation risk increases the longer you hold a bond. What is the interest rate risk of bonds? - An increase in the interest rate means an increase in redemption yield and it push prices of bonds down ( bad news). As a result of increase in interest rates, coupons can be re-invested at a higher rate. (the good news) - A decrease in the interest rate means a decrease in yield and it pushes prices of bonds up. (good news) As a result of decreasein - Competitive Bids: > These are priced bids for at least £1,000,000. > Those who bid the highest prices will get as much as they have subscribed for. - Non- Competitive Bids: > These are non-priced bids between £1000 - £500,000 nominal value. > In a non-competitive bids, the investor gets as much stock as they requested, at the average accepted bid price for that particular auction( ie. the weighted average paid by successful competitive bidders) How are fixed income securities traded and settled in the secondary market? - In the secondary market, debt securities (bonds) can be bought and sold through a stockbroker. - In the secondary market, private investors are able to deal in gilts which are already in issue, directly with the DMO, on a execution only basis ( no advice given, the investor must make the decisions). The service is called the retail gilt purchase and sale service and it's operated by a firm called Computershare. - Another way we are able to deal with deal securities is through the retail bond market. Retail bonds are generally offered by intermediaries (ie. wealth managers) to their retail clients. Bonds are traded in units less than £50,000 nominal value, and have maturities between five and 10 years. The LSE launched the Order Book for Retail Bonds( ORB) platform as an order - driven trading service providing access to a range of gilts (settlement time T+1) and UK corporate bonds (settlement time T+2), in response to demand from retail investors in fixed interest securities. - The clean price is the price of a coupon bond not including accrued interest payments. Dirty price is the price of a bond that includes accrued interest between coupon payments. Accrued interest is the amount of loan interest that has already occurred, but has not yet been paid by the borrower and not yet received by the lender. Dirty price = Clean price + Accrued interest What is a bond market index? A bond market index is a composite listing of bond or fixed - income instruments and provides a statistic that can be used to measure the performance on the portfolio management process. How are bond indices classified? - By bond type: Government bonds, corporate bonds, high yield bonds, asset backed securities (ABS). - By Credit Rating - By Maturity Date What are the features of bond indices? - Most bond indices are weighted by market value (market capitialisation) like share values. - Harder to replicate than an equity index (stock market indices) due to large number of issues. old issues replaced with new ones with different characteristics, prices rely on a dealer market. - Indices have an average 'duration' - sensitivity to interest rates When applied to calculate fixed income securities, interest rate sensitivity is known as the asset's duration. This is one way to determine how interest rates affect a fixed-income security portfolio. The higher a bond or bond fund's duration, the more sensitive the bond or bond fund to changes in interest rates. - Capital index vs. total return index A total return index (TRI) is different from a price index. A capital index only considers price movements (capital gains or losses) of the securities that make up the index, while a total return index includes dividends, interest, rights offerings and other distributions realized over a given period of time. -Preference Shares : gives their holders superior rights and security, over and above those of ordinary shareholders. What are the features of ordinary shares? - Holders have voting rights (vote on how company is run) - Variable Dividends (due to risk in investing in shares) - E.g: Dual Class Shares What are the features of Preference Shares? - Fixed Dividends - No Voting rights for holders -E.g: Convertible Shares What are the risks with investments and shares? - Capital Growth (potential capital losses) - Income from Dividends (Dividends may not be paid) - Liquidity (Can the shares be traded at a fair price?) - Volatility (Share prices can be prone to 'swings' in prices) -Company Risk (Nature of industry; management competence; financial performance; liquidation) - Market Conditions (- Macroeconomic factors; political events, etc) What are corporate actions? This is a collective term for a range of actions a company can take which affects its holdings, benefits or rights of its shareholders. Explain Corporate Action 1 - Capitalisation Issue ?