Chapter 1 Asset Classes

14 questions 1.1 The Role and Characteristics of Cash Deposits

Liquidity and rates of interest • Why hold cash? - Liquidity – instant access • Emergency funds, planned spending - ‘Safe’ • Capital unlikely to be lost - No • Interest is paid - Real return • Rates of interest - Interest is a percentage of funds deposited • The higher the deposit, the higher the rate - Longer-term deposits • Generally higher rates (not always the case – if rates falling) - Fixed or variable interest rates

www.fitchlearning.com 1.2.1 Gross and Net Interest

Gross and net interest • Gross (typical) - Paid before the deduction of income tax • Net (e.g. distributions from bond funds) - After tax at 20% Example • A building society is quoting 6.4% gross on a deposit account - What is the effective after-tax rate for a BRT and a HRT?

www.fitchlearning.com Annual equivalent rate (AER) • Annual equivalent rate (AER) - True to compare ‘like for like’ (12-month period) - AER is usually quoted gross - Example: an interest rate of 6% is paid quarterly – what is the AER? - Example: an interest rate of 6% is paid monthly – what is the AER? • Compounding - Interest can be paid at differing time intervals - The more frequent the payment, the more benefit from compound interest • If compounding periods are discrete, CF = (1+(r / j))n*j • If compounding periods are continuous, CF = ert

www.fitchlearning.com 1.5 Statutory Protections

The Financial Services Compensation Scheme • If deposit taker fails – Financial Services Compensation Scheme - Administered jointly by the FCA and PRA - Maximum protection of £75,000 per account holder (UK sterling deposits only) - Maximum payouts are per person, per institution

• Financial Ombudsman Service (FOS) - Complaints against regulated financial services providers - Free dispute resolution service - Can award compensation up to £150,000

www.fitchlearning.com 1.7.1 National Savings and Investment Products

NS&I products offered by the Government • Overview - The only truly risk-free deposits – government backed - NS&I is an agency of the Chancellor, accountable to the Treasury • Summary

National Savings and Investment Products

Interest Net of 20% Gross but taxable Tax free

• Guaranteed growth • Investment account • Index-linked savings bond* • Direct saver account certificate* • Guaranteed income bond • Income bond • Fixed interest savings Products • 65+ bonds* • Guaranteed bond certificate* • Children’s bonus bond • Direct ISA • Premium bond

* Not currently available

www.fitchlearning.com 1.9 Peer to Peer Lending

What is peer to peer lending? • Lending to individuals without using a financial intermediary - Independent companies match borrowers and lenders online in return for a fee - Also called Crowdfunding • Risks - Default by borrowers - Loans sometimes pooled to diversify risk • Returns and taxation - High APR compared to high street - Interest is received gross and must be declared in full to HMRC • Possible to hold P2P ISA from April 2016 • Regulation - Depositors have no recourse to the FSCS for losses they incur - Firms that operate in this must be FCA registered - FCA undergoing a full review of the market

www.fitchlearning.com 2. Securities

Gilts: UK Government bonds Name Redemption • Features of gilts The name The year when given at the gilt is repaid issue Coupon Expressed as an Code 122 annual % of the GBX00001144KK00 6½ PER CENT TREASURY 2018 nominal value Principal and interest charged on the National Loan Fund, witehc rourse to the Consolidated Fund of the United Kingdom Nominal value Repayable at par on the 7 December 2018 HOLDING NUMBER Interest payable hal-fyearly on 7 June and 7 December CERTIFICATE NUMBER The capital payment 555-XZ333333 555-XZ333333 £100.00****** The holder receives

MR FREDERICK BLOGGS at redemption 24a ACACIA AVENUE ARBINGER SURREY SSY 345

THIS IS TO CERTIFY THAT THE ABOVE-NAMED IS/ARE THE REGISTERED HOLDER(S) OF ONE HUNDRED POUNDS 61/2 PER CENT TREASURY STOCK 2018 17 JUNE 2002

CHIEF REGISTRAR OF ENGLAND

IMPORTANT: The Bank of England should be notified immediatelya onfy change of address of any of the above stockholders No transfer in whole or part of this holding represented by thcisertificate will be registered until this certificate has beedne livered to the Bank of England The stock is transferable in multiples of 1p

• UK Government raises funds for the PSNCR (CGNCR + LGNCR + PCNCR)

www.fitchlearning.com 2.2 UK Government Bonds

Gilts: UK Government bonds • Categories of gilt

Gilts

Index-linked Non-index-linked • Coupon and redemption linked to RPI • Shorts < Seven years to redemption • Inflation protection • Mediums 7-15 years to redemption • Longs >15 years to redemption • Undated

www.fitchlearning.com Discount Instruments

Treasury bills • Issued by the UK Government via the DMO • Zero coupon (pay no interest – buy at a discount) • Tradable - Their value fluctuates • Terms: - One month, three months, six months most popular • Minimum bid at tenders £500,000 - Bids made through Treasury Bill Primary Participants

Zero coupon bonds • Pay no interest, issued at a deep discount - E.g. issued at £60 per £100 nominal • Taxed as though income is paid – no CGT on the gain

www.fitchlearning.com 2.2.5 Local Authority Bonds

Local authority bonds • Features - Interest is paid to 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 • Local authority fixed - Not marketable - Investors must hold until the maturity date • Local authority negotiable loans (‘yearlings’) - Have a life of no longer than two years - Issued at par - Can be traded

www.fitchlearning.com 2.3 Corporate Bonds

Corporate bonds: security

Corporate bonds

Debentures Loan stock Secured debt securities Unsecured debt securities

Fixed charge Floating charge Over assets Over assets

www.fitchlearning.com 2.3 Corporate Bonds

2.3.1 Permanent interest bearing shares (PIBS) • Issued by building societies • Fixed interest security traded on the LSE - Interest paid gross/taxable – twice a year - No obligation to pay interest – non-cumulative - Irredeemable – no fixed term - In demutualisation PIBS convert to perpetual subordinated bonds (PSBs) • Higher risk than gilts, illiquid • PIBS holders are members of the Building Society • Not protected by the FSCS

www.fitchlearning.com 2.3 Corporate Bonds

2.3.4&9 Convertible loan stock • Straight bond plus conversion to buy shares • Attractive to many investors - The certainty and predictable income streams of a loan stock; and - The potential for growth that shares offer • Attractive to the issuing company - A convertible may have a better chance of raising capital - Interest on a company’s loan capital is paid ‘before tax’ 2.3.10 Contingent Convertible bond (CoCo) • Converts into equity when a specified condition is met (hybrid) • Condition set by the issuing company to the advantage of the issuing company - Capital adequacy concerns - Regulatory mandates - Market events • High

www.fitchlearning.com 2.3 Corporate Bonds

2.3.5 Eurobonds • Issued in ‘bearer form’ • Issued internationally • Issued in a eurocurrency - A other than that of the market of issuance • No withholding tax

2.3.7 Floating rate notes • Coupon is variable and is reset at varying intervals (every one to six months) - E.g. 0.5% above LIBOR reset every six months • Attractive to investors in times of volatile interest rates

www.fitchlearning.com 2.5 Investment Risk and Debt Securities

Risk of bonds • Credit risk (issuer risk) - Corporate bonds, PIBS, local authority bonds - Default risk • Senior vs. subordinated • Secured (e.g. debentures) vs. unsecured (e.g. loan stock) - Downgrade risk • Changes in ratings - Economic environment changes • GDP changes • Unemployment • Liquidity risk - Less of a problem for large issues • Inflation risk - Coupons worth less in real terms

www.fitchlearning.com 2.5 Investment Risk and Debt Securities

2.5.2 Interest rate risk

The bad news The good news Bond prices generally Coupons can be reinvested fall when rates rise at a higher rate

Interest rates rise

Interest rates fall The bad news The good news Coupons are reinvested Bond prices generally at lower rates rise when rates fall

www.fitchlearning.com 2.4 Investment Returns on Debt Securities

2.4.4 and risk • Interest rates determine the return required from the bond • Bond prices have an inverse relationship with interest rates - A rise in interest rates will lead to a rise in the bond’s required yield (YTM) and its price will fall • The sensitivity of the bond’s reaction to an interest rate move is determined by: - Remaining life • Longer • Shorter - Coupon size • Larger • Smaller

www.fitchlearning.com 2.4 Investment Returns on Debt Securities

2.4.4 Volatility and risk • Macaulay Duration - The relative sensitivity of bonds to changes in interest rates is measured by a factor called (Macaulay’s) duration • The longer the duration the more sensitive a bond • Modified Duration - Modified duration shows the approximate percentage change in a bond’s price for a 1% change in yields % change in bond’s price = (modified duration) x change in yield

www.fitchlearning.com 2.4 Investment Returns on Debt Securities

2.4.1 Running yield • Uses: - Income-seeking non-taxpayers - Irredeemable bonds

Gross annual coupon Running yield = x 100% Market price

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2.4 Investment Returns on Debt Securities

2.4.3 Gross redemption yield • Return on coupon, capital and reinvestment

Example An purchases an eight-year 3.5% coupon bond at a market price of £106.50 (per £100 nominal). The approximate gross redemption yield is calculated as follows:

£ . Running Yield (coupon income) × 100 = 3.29% £ .

£ . Profit (or loss) at redemption × 100 = −0.76% £ .

Gross redemption yield 2.53%

Net redemption yield (apply income tax payable to the running yield).

www.fitchlearning.com 2.4 Investment Returns on Debt Securities

2.4.5 The yield curve

Normal/Upward Flat Downward sloping Yield Yield Yield

Maturity Maturity Maturity

www.fitchlearning.com 2.6 Dealing in Debt Securities

• - Via the Debt Management Office (DMO) at auction • Non-competitive (approved investors/computer ) - Non-priced bids between £1,000 and £500,000 nominal value - Pay a volume weighted average of the successful competitive bids • Competitive (gilt-edged market makers) - Priced bids for at least £1,000,000 - Pay price bid if successful • - Via a - Via DMO gilt purchase and sale (approved investors/computer share) - LSE for Retail Bonds (ORB) • Order driven platform for gilts (settle T+1) and UK corporate bonds (settle T+2) • Continuous trading between 08.45 and 16.30 • Automatic trade reporting and trade publication

www.fitchlearning.com 2.6 Dealing in Debt Securities

2.6.4 Clean and dirty prices

Price Cum coupon period Cum coupon period Dirty price

Clean price Ex coupon period

Time

Six months Coupon paid date

Ex-coupon date

www.fitchlearning.com 2.7 Bond Indices

• Types of bond index - By bond type: government bonds, corporate bonds, high yield bonds, ABS - By credit rating - By maturity date • Features - Most use market capitalisation as their weighting method - Harder to replicate a bond index than an equity index – large number of issues, old issues replaced with new ones with possibly different characteristics, prices rely on a dealer market - Indices have an average ‘duration’ – sensitivity to interest rates - Capital index vs. total return index • Included in indices - Straight bonds, zeros, strippable bonds (not yet stripped) • Excluded from indices - Coupon strips, principal strips, FRNs, index-linked, convertible, bonds with other options e.g. putable, callable, irredeemable

www.fitchlearning.com 2.8 Bonds Summary

2.8.2 Investing in bonds • The role of fixed interest securities: - Steady cash flows - Liability matching - Diversification • Advantages of debt securities - Regular income - Higher interest rates than savings accounts - Relatively safe return of principal - Typically less volatility than shares • Disadvantages of debt securities - Conventional bonds offer no hedge against inflation - Prices fluctuate in relation to interest rates - Typically lower returns than shares over the term

www.fitchlearning.com 3.2 Different Types of Share

Ordinary shares • Features - Variable - Voting rights • Types - Redeemable shares • Callable by the company - A and B shares (dual class) • Indicates differing rights - Deferred shares • Voting rights but dividend deferred until a future date - Deferred ordinary shares • Rights deferred until a specified event

www.fitchlearning.com 3.2 Different Types of Share

Preference shares (take preference over ordinary shares) • Features - Fixed dividends - Generally no voting rights • Types - Cumulative • The right to receive that dividend is rolled over into the next period - Convertible • The right to convert into ordinary shares - Participating • Opportunity for further dividend - Redeemable • The right for the issuer to buy back the shares

www.fitchlearning.com 3.1 Equity

Debt vs. equity Debt Equity

Creditor vs. Creditor Shareholder shareholder

• Debt holders get paid before • Shareholders get paid after shareholders debt holders • Senior secured debtors get Who gets paid first paid first • Preference shareholders • Unsecured holders, junior and get paid before ordinary subordinated debtors get paid shareholders in order of priority

More risky than debt as Investor risk Less risky than equity as paid first dividends are not guaranteed and are last in line to be paid

Lower expected returns H i g h er expected returns Investor returns due to lower risk due to higher risk

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3.4 Investment Risk and Shares

Two potential sources of return and losses • Capital growth - Potentially capital losses • Income from dividends - Dividends may not be paid

Two components of risk • Systematic risk (Market risk) - Political events - Economic events - Financial events • Non-systematic risk (Specific risk) - Nature of industry - Competence of management - Fundamentals of the company

www.fitchlearning.com 3.5 Corporate Actions

3.5.4 Rights issues • Where a company wants to raise more capital - New shares issued on a pro rata basis to shareholders - The existing shareholders have the ‘right’ to participate • Protects them from the effects of dilution of their shareholding - Do not have to take up the right • New shares issued at a discount but rank ‘pari passu’ with the existing shares - Theoretical ex-rights price (share price after the rights issue)

• E.g. an investor holds 40 shares in PQF plc, with a current share price £4.50 and 1 for 2 rights issue at £3. What is the theoretical ex-rights price?

www.fitchlearning.com 3.5 Corporate Actions

3.5.2 Capitalisation/Bonus/Scrip issues • Increasing the number of shares in issue – without raising more money • More shares and lower price improve the marketability of the share • New shares issued on a pro rata basis to shareholders - E.g. 1 for 4 capitalisation issue means: one new share for every four existing • Other issues • total not affected • Investor’s total net worth the same • Share price will fall as a result of the issue

3.5.3 Share split / consolidation • Shares are literally divided (combined for a consolidation) into smaller (or larger) tradable portions • Attempt to enhance tradability

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3.6 Share

The listing of shares • What is listing? - Meeting the requirements of a listing authority (e.g. UKLA) - A listed company that is admitted for trading – quoted company - Unquoted company – too small to join a

• Why do companies want to list? - To raise capital, increase liquidity, enhance credibility and improve efficiency

• Markets - The main market – London (LSE) • Recognised investment exchange (RIE) - Alternative Investment Market (AIM) • LSE’s junior market - Agency and principal dealing

www.fitchlearning.com 3.7 Dealing in Shares

Share dealing • Three ways to deal - Execution-only • Client instructs - Advisory • Advice given, client decides - Discretionary • Broker is given the discretion to buy and sell on behalf of the client • Two key market systems - Order driven • Stock Exchange Electronic Trading System (SETS) – large caps - Quote driven • Stock Exchange Automated Quotation System (SEAQ) – small caps - Dual capacity - Market makers • Settlement (CREST) - Membership benefits - T+2 i.e. money must be paid for a trade within two business days

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3.7 Dealing in Shares

3.7.4 Dealing costs • Purchase costs - Spread between bid/offer (’s profit) - Broker’s commission - Stamp duty/SDRT 0.5% – if via CREST rounded to nearest 1p, if paper based round up to nearest £5 - Panel on and Mergers levy – flat £1 on sales/purchases over £10k

Purchase example: Sale example: £20,000 in shares = £20,000 £30,000 sold = £30,000 Commission 1.5% = £300 Commission = £450 Stamp duty 0.5% = £100 PTM levy = £1 PTM levy £1 = £1 = £29,549 = £20,401

www.fitchlearning.com 3.7 Dealing in Shares

3.7.5 Share values • Nominal value vs. market value - Nominal value of a share – accounting term - Market value of a share – the market price of a share • Market capitalisation - Number of x market share price • Cum- or ex-dividend - Cum-dividend • The buyer is entitled to the next dividend - Ex-dividend • The seller is entitled to the next dividend

www.fitchlearning.com 3.8 Equity Indices

Types of equity indices • World or global index - E.g. MSCI World, S&P Global 100

• National index - E.g. FTSE 100, S&P 500, Nikkei 225

• Weighting methods - Market capitalisation weighted • E.g. Hang Seng, FTSE 100, S&P 500 - Price weighted • E.g. Dow Jones Industrial Average - Modified market cap weighted • Hybrid between cap and equal weightings • E.g. 100

www.fitchlearning.com 3.9 Measuring the Performance of Shares

Earnings per share Price/Earnings ratio

EPS = Earnings P/E ratio = Price per share Number of ordinary shares

Notes Notes • Earnings means profits available to ordinary • P/E ratio is a relative valuation multiple shareholders • A low P/E indicates a low share price which may • Growth in earnings and EPS indicates a successful indicate a higher risk company or an undervalued company company • Steady growth in EPS indicates a consistent company • A high P/E indicates a high share price which indicates • Analysts often aim to estimate future earnings for a strong company with growth potential or an companies overvalued company

Example Example • ABC plc has announced profits after tax of £2m • ABC plc has announced profits after tax of £2m • It has 2m shares in issue • It has 2m shares in issue • Calculate the EPS for ABC • ABC’s share price is £10.00 • Calculate the P/E ratio for ABC EPS = £2m / 2m = £1 P/E ratio = £10.00 / £1.00 = 10x

www.fitchlearning.com 3.9 Measuring the Performance of Shares

Dividend yield Dividend cover

Dividend yield = Dividend paid per share Dividend cover = Earnings Share price Dividends paid Notes • Can be gross or net (adjusted for tax) Notes • Measures the income return from shares • Indicates sustainability of the dividend • Value companies (low share prices) have higher dividend yields but may indicate higher risk • Literally, how many times a company could have paid its dividends • Growth companies (more reinvestment of income and higher share prices) have lower dividend yields which • Indicates how much profit is re-invested rather than may indicate lower risk being paid out • A ‘prospective’ dividend yield estimates future earnings and dividends Example • ABC plc has announced profits after tax of £2m Example • It has 2m shares in issue • ABC plc has announced profits after tax of £2m • ABC pays out £0.9m in dividends • It has 2m shares in issue • The ABC share price is currently £10 Dividend cover = £2m / £0.9m = 2.2 • ABC pays out £0.9m in dividends • ABC could have afforded to paid its dividends more Dividend per share = £0.9m / 2m = £0.45 than twice; this indicates a fair degree of financial Dividend yield = £0.45 / £10 = 4.5% strength

www.fitchlearning.com 3.9 Measuring the Performance of Shares

Gearing ratio per share

Gearing ratio = Long-term liabilities NAV = Assets - Liabilities Capital employed Shares in issue

Notes Notes • Capital employed is the total assets of the company • The net asset value is used a lot to value investments less liabilities due within one year in collective investment vehicles such as unit trusts, open-ended investment companies and investment • Debt is riskier (from the issuers’ point of view) than trusts. equity as it typically requires fixed and obligatory interest payments • The higher the proportion of debt a company has the Example greater the risk to shareholder dividends • ABC plc has total assets of £12m • It has liabilities of £8m Example • It has 2m shares in issue • ABC plc has total debt of £8m of which £1m is due • Calculate its NAV per share within one year • It has total equity of £4m NAV = £12m - £8m / 2m = £2 per share • Calculate its gearing ratio

Gearing ratio = (£8m-£1m) / (£8m + £4m - £1m) = 64%

www.fitchlearning.com 3.10 Selecting Equities and Equity Funds

Equity fund management styles • Passive, active or semi-active fund management style • Growth investing - Aggressive investment style - investing - High P/E ratios - Growth at reasonable price (GARP) • Income investing - Mature companies with fewer growth opportunities - Sustainable dividend yields • - Distressed companies, higher risk, low P/E ratio, Investing in equities • Advantages - Strong returns over long-term, inflation hedge, liquidity • Disadvantages - Volatility, risk of firms failing, smaller companies have increased risk

www.fitchlearning.com 4. Property

4.1 Residential versus commercial property • Characteristics of residential property - High levels of owner occupation in the UK – psychological benefits - Property may be part of retirement planning – downsize to release capital - Buy-to-let market increased rapidly - Collateral for loans - Rent-a-room scheme (£7,500 tax relief) - Gearing • Important in the property market – can be beneficial and disastrous - Impact of increases in interest rates, change of circumstances

• Characteristics of commercial property - Dominated by insurance companies and pension funds - Longer leases - Retail, offices and industrial - Retail shopping centres are more evenly distributed across the country - Offices and industrial property concentrated in London and South-East

www.fitchlearning.com 4. Property

Direct property investment • Advantages - Another asset class - Rental yields giving real returns - Typically long-term appreciation in values

• Disadvantages - Illiquidity and transaction costs - Cyclical fluctuations in the housing market • Possible depreciating values - Quality of tenants • Maintenance costs - Void periods • Affects the yield - Stamp duty land tax (SDLT)

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4. Property

4.4 Returns from rent • Returns - Cyclical, not as good an inflation hedge as equities - Vulnerable to overseas influences – FX rates, taxes on UK property - High growth, low inflation stage of the economic cycle is preferred

- =

www.fitchlearning.com 4. Property

4.10 Valuation measures • Property market cycles - Oversupply leads to market weakness - Shortage of supply leads to market strength

• Methods used to estimate the value of income producing properties - Simplest method

• =

- Most common method

• =

- Net operating income = gross rent - cash operating expenses

www.fitchlearning.com 4.11 Indirect Property Investment

Indirect property investments • Property unit trusts and open-ended investment companies - Invests directly into commercial property and property company shares - Diversified portfolio of commercial property for investor (max 15%) - Less liquid than listed funds • Property Authorised Investment Funds (PAIFs) - Direct investment in property • Property income is ring fenced within the funds, and is tax exempt • All other income is subject to corporation tax at 20% - The fund pays out three types of income: property income, other taxable income, and UK dividend income - In order to qualify as a PAIF, the fund must meet the following criteria: • Structured as an OEIC • 60% of net income is derived from the property investment business • 60% of the total assets are derived from the property investment business • No corporate investor can hold 10% or more of the PAIF shares

www.fitchlearning.com 4.11 Indirect Property Investment

Indirect property investments • Investment companies - Property investment trusts • Only permitted to invest in shares, not in property directly - REITs • Invest directly in property • Capital and income generated from the property - Both benefit (suffer) from gearing • Property company shares - Typically highly liquid but suffers systematic risks of the equity market

www.fitchlearning.com 5. Alternative and Specialist Investments

Alternative and specialist investments • Traditional investments - Stocks, bonds and cash • Alternative investments - Property, hedge funds, commodities, private equity, structured products, FX, forestry • Chattels collectables - Coins, stamps, jewellery, art, antiques, toys, books, comics, classic cars, race horses, fine wine, memorabilia, autographs, posters • Disadvantages of chattels - Illiquid, hard to value, fashions change, storage/insurance, no regulation, forgery, high dealers’ charges, no income generated • Benefits - Diversification • Reduces risk in a portfolio – lower correlations with traditional assets - Other • Chattels under £6,000 exempt from CGT

www.fitchlearning.com Tax summary Income Capital Withholding Stamp duty Cash Yes No No No NS&I Variable No Variable No Gilts Yes No No No Corp. debt Yes No 20% No (qualifying) Corp. debt Yes Yes 20% Yes (convertible) Equity Yes Yes No Yes Property N/A* No N/A Yes (primary res) Property Yes Yes No Yes (investment) Chattles No Yes† N/A No

* Rent a room scheme (£7,5000 allowance) † £6,000 threshold on chattels

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