R02: The main asset classes

Transcription

1 R02: The main asset classes These are: Cash (deposits) Fixed Rate (Gilts & Corporate Bonds) Equities (shares) Property Commodities Alternatives Cash Notes and Coins sitting in a wallet or in a box don't produce anything Banks and building societies offer deposit accounts These pay interest to the investor and the money is normally repayable on demand. Accounts are usually either instant access accounts or notice accounts If investor wants money immediately from a notice account there is normally a penalty in the form of lost interest. Interest rates fluctuate and are influenced by the rate set by the Bank of England Interest is taxable as savings income. Bank and BS interest is paid gross. Tax is also due on any interest paid by an institution based outside the UK if the individual is UK resident. Savers can make use of the Personal Savings Allowance and the 0% starting rate Deposit accounts can be placed in an ISA which means no tax is payable on the interest National Savings & Investments (NS&I) is a Government Agency offering mainly deposit type accounts Savings Certificates and Children's Bonds are tax free For all their other products interest is taxable Risks Deposit accounts are low risk but not risk free products Risk of provider collapsing (not applicable to NS&I) There is compensation should the provider collapse of 75K per individual per banking licence. Other risk is inflation risk. If interest rate after tax (net rate) is less than inflation then amount invested is losing value. 1

2 Compounding and Discounting One of these is always asked in R02. A compounding question will give you the initial amount of money, a rate of return (or interest rate) and the term of the investment. You will be asked to calculate the value at the end of the term. Callum is investing 10,000 for 6 years. The expected rate of return is 4.1%. How much will the investment be at the end of the term? This can be done on a scientific calculator but there is a work around using a basic calculator. Enter the interest in this form Press the multiply sign (x) twice Enter the principal 10,000) Press the equal sign(=) six times (or number of years in the question) This will give you 12, NOTE. Not all calculators work in the same way. You may have reverse the process, (starting with the principal and then putting in the interest) or you may only need to press the multiply key once. You should practice with the calculator you will use in the exam. A discounting question will give you the final figure, the rate of return, the term and ask you to calculate how much you need to invest today. Ron needs a sum of 16,000 in 5 years time. If the rate of return is 4.8% what amount needs to invested now? Enter the target amount Press the divide key twice Enter the rate of return in the form Press the equal sign 5 times (or number of years in question) This will give you 12, A third possible question will give you the starting and end amount, the term and you must calculate the rate of return. This can only be done on a scientific calculator but again there is a work around. Since R02 is a multiple choice paper there will be four possible answers. Whilst it is time consuming you can select each option and compound up the starting amount to see if you get end amount. 2

3 Fixed Interest This is a method used by the Government and companies to raise capital by borrowing money at a fixed rate for a fixed term. A fixed interest loan by the Government is called a Gilt, for a company it is a Corporate Bond. (CB) Unlike a deposit account the investor cannot ask the borrower to pay them back until the end of the term. However, the Bond can be traded on the Stock market. This is the difference between a Gilt/CB and a fixed rate bond from a bank. With the latter, the borrower can always get their money back before the end of the term albeit with the loss of some interest. Interest is normally paid twice a year The benefit to the Government and companies is that the cost of their borrowing is fixed and the loan does not need to be repaid until a set date in the future. The benefit to the investor is that the level of income won't drop and the money will be returned at the end of the term. New issues of Gilts are handled by the Debt Management Office (DMO) and investors can subscribe to new issues directly with them Existing Gilts and CBs are traded on the Stock Exchange through stockbrokers. The interest rate offered by the borrower is known as the Coupon. This will be determined by interest rates at the time of issue, the credit worthiness of the borrower and the market s view of future inflation. The Government has the best credit rating since they can't go bust. In the final resort the UK can print money to pay off its debts. Members of the Eurozone don't have this option which is why there is concern that Greece will be unable to pay off its debts. Companies can default and so must offer a better rate than the Government. The financial strength of companies will vary so the weaker the company the higher the rate will be demanded by the market A Bond has a Par of Nominal Value. This is always quoted as 100. During the life of the Bond its Market Value will fluctuate and could be higher or lower than the par value. This will be determined primarily by the level of current interest rates compared to the coupon rate. If the coupon rate was 4.5% but market rates were 0.75% the market price of the Gilt would be more than 100. (The gilt would produce 4.25 of income compared with 75p in the market) What an investor is buying is the right to receive a fixed income until redemption and the market price reflects the value of that income. As the Bond gets closer to its redemption date its price will gravitate back to 100 since that is what the holder will receive at redemption. 3

4 Here are these details for three gilts recorded on December Redemption date Coupon Market Price 7 December % September % December % Before going on you need to be aware of the distinction between clean price and dirty price. The December 2027 issue will pay interest on December 7 and June 7. If it is sold on 7 April four months interest will have accumulated, about 1.41 for each 100. The buyer must pay this to the seller in addition to the market price. The price without the accumulated interest is the clean price. The price with the interest is the dirty price. In the table market price refers to the clean price. The clean price of all of them is higher than the 100 par value. That means that anyone buying them today will make a capital loss if they are held to redemption. This reflects the current low interest rates. Using the clean price, coupon and term to redemption it s possible to calculate the key return; Gross Yield to Redemption TIP This is always tested in R02 The first step is to calculate the daily or running yield the formula for which is: Coupon/Clean Price x 100 Referring to the previous table the running yields would be: December / x 100 = 3.31% September / x 100 = 3.21% December / x 100 = 2.68% If the clean price is greater than 100 the running yield will always be lower than the coupon. Running yield is not that useful a measure as it does not take account of the gain or loss that will be made if it is held to redemption but Gross Yield to Redemption does that. There are 4

5 different ways to calculate this but for the exam the simplified or Japanese method will be used. Taking the 2034 gilt the running yield has been calculated as 3.21% and this is the starting point in the calculation If held to redemption there will be a capital loss of Assuming there are exactly 18 years to redemption this is an average loss of 2.22 a year. This is then divided by the clean price and multiplied by 100 to get a percentage. Therefore: 2.22/ x 100 = 1.59% This is then subtracted from the running yield so 3.21% less 1.59% = 1.62%. The full formula for YTR when the clean price is higher than 100 is: Running yield LESS Capital loss/number of years to redemption x 100 Clean Price In practice you should tackle the calculation in this order: 1. Calculate running yield 2. Calculate capital loss if held to redemption 3. Divide this by number of complete years to redemption. 4. Divide this by the clean price and multiply by 100 to get a percentage. 5. Subtract this from the running yield. TIP Exam questions tend to focus on the current economic situation. Today all gilts are trading at a premium; that is the clean price is greater than 100. This will always result in a loss if held to redemption so the YTR will always be lower than the running yield. In the unlikely event that you will be given a clean price that is lower than 100 the formula would be: Running yield PLUS Capital gain/number of years to redemption x 100 Clean Price There is a mathematical link between the market price of a gilt and its GRY. Therefore: If the market price rises, the GRY falls. If the market price falls, the GRY rises 5

6 Here is a further selection of Gilts with data from 2014 and December Redemption date Coupon Clean Price YTR March % % 0.62% 7 Sep % % 1.80% 7 Dec % % 1.92% Note these points: As the price has risen the YTR has fallen. The YTR increases as the term to redemption increases. If plotted on a graph it would look something like the first illustration. This is called a normal distribution curve as we would expect investors to demand a higher return the longer the money is invested. Occasionally the YTR may be lower for the longer term. This is called a reverse curve as investors are more concerned over short term inflation which is shown in the second illustration. The YTR is a useful measure to show the return on different issues. It is also an indication of the rate the Government can borrow. Investors and analysts tend to compare the YTR of different government bonds that are repayable in 10 year s time. 6

7 At the time of writing (December 2016) a selection of yields on 10 year bonds were as follows: Brazil 11.38% India 6.58% Japan 0.05% USA 2.57% Risks Gilts can be seen as low risk investments in that the Government cannot default. Someone who invests 10,000 in a new Gilt knows that they will get 10,000 back at maturity and a guaranteed income in the meantime. They are exposed though to inflation risk. The income cannot increase so will fall in real terms. In addition you will only get back the original investment and will almost certainly be less in real terms than at the start. Gilts/CBs can be traded and this can result in a loss or gain on the original investment. Corporate Bonds are also exposed to the risk that the company can default. Gilts/CBs will be less volatile than shares because they have an underlying value. That is the capital repayment at maturity. Tax Interest is classed as savings income. Gilt income is paid gross, Corporate Bond income is paid net No capital gains tax is payable on Gilts or qualifying Corporate Bonds Individual investors can use the Personal Savings Allowance and the 0% starting rate. Indexed Link Gilts The previous section described conventional fixed interest. The Government also issues Indexed Linked Gilts These offer a coupon rate plus RPI. The maturity value is also linked to RPI. The RPI used to calculate interest is set 3 months before the income distribution is made Corporate Bonds These are issued by companies as a way of raising capital. As with Gilts, bondholders have a right to receive coupon plus return of their capital at the end of the term. Unlike the UK Government companies can fail so there is default risk. As a consequence: Coupons are generally higher than Gilts and the greater the risk of default the higher the coupon has to be. Terms are generally shorter with the maximum being usually 10 years. 7

8 Historically in the UK issuers of CBS have tended to go to the institutional market such as banks and insurance companies. Recently there have been issues aimed primarily at the individual investor. Bonds can be secured or unsecured. Secured bonds are a lower risk than unsecured since if the company defaults, the secured asset can be taken Secured bonds are often referred to as Debentures. They can have a fixed charge, that is there is a specific asset, or a floating charge where it is held over any unsecured assets of the borrower Convertible loan stock is a bond which offers the chance to convert to shares. This will probably mean that it trades at a higher price than an ordinary loan stock. Permanent Interest Bearing shares (PIBS) are a form of corporate bond issued by a building society. If the BS converted to a PLC, they come Perpetual Subordinated Bonds (PSBS) Both are undated and the borrower is under no obligation to repay the debt which means they are most susceptible to changes in interest rates. They rank behind other depositors and creditors and do not qualify for compensation under FCS if the bank goes into liquidation Mini Bonds A recent development has been the introduction of mini bonds. The characteristics of these are: They tend to be issued by smaller companies. They are offered directly to the public They are not tradable on the stock market. From the borrower s point of view they are easier to launch than a conventional corporate bond. Investors may be attracted by a high coupon but as they are not tradeable they are locked in until the bond matures. A number of these bonds have defaulted and investors have lost their entire investment. They fall into something of a regulatory grey area as they are not regulated products although the financial institution that set up the bond for the borrower may have been FCA authorised. Like other CBs there is no compensation under the FSCS. If an FCA authorised firm recommended the bond to a client there may be a valid complaint if it can be shown that the product was unsuitable for the client s needs. Non UK Sovereign Debt. All Governments issue bonds. As we have seen these may offer higher yields than the UK but all are subject to greater risk. If the currency is in anything other than UK then there is currency risk which may work for or against the investor. 8

9 There is also default risk. If a country issues bonds in its own currency it can, if all else fails, print or create more money to pay off the bond holders. This though would lead to inflation and devalue the real value of the bond. If it borrows in another currency such as the US Dollar or doesn t have its own currency as in the Eurozone then default is possible. Whilst countries can default they cannot go into liquidation. If a company defaults the bondholders may get something back when all the assets are liquidated. There is no such provision for sovereign debt holders as they cannot take over any of the country s assets. Nor can they take over the running of the country. 9

10 Shares Shares are issued by companies to raise capital. Shares are issued when a company seeks to have itself listed and traded on a recognised stock market. This is an Initial Public Offering (IPO). This can be arranged by either a fixed or tender price. Most IPOs are underwritten. There is always the risk that there will be insufficient demand for the shares so an institution agrees to buy any unsold shares. A fee is charged for this. To get a full listing on the main stock exchange the business must usually have at least three years accounts, a market capitalisation of at least 700,000 and 25% of the shares issues must be in the public s hands. If a business doesn t qualify to get a full listing it may opt to get listed on a junior market such as the Alternative Investment Market (AIM) in London Unlike a bondholders shareholders have no guaranteed return. The company is under no obligation to buy back the shares and neither have they any certainty that they will receive a dividend. All shareholders are entitled to is the payment of a dividend if one is made. They are also entitled to one vote per share. The bulk of a company's share capital will be in ordinary shares. These entitle the owner to 1 vote for each share held. In the past family companies would often split their shares into voting and non voting shares, usually termed A & B shares. This practice is not now encouraged Preference shares have priority over ordinary shares in terms of dividend payment. The dividend is normally fixed and they have no voting rights Cumulative preference shares give the holder the right to receive a dividend in a later year if not made in an earlier one. Non cumulative preference shares don't have this right Participating Preference shares get an additional dividend in addition to the fixed one Redeemable means that the preference share will be purchased by the company at some point in the future Convertible preference means that they can be converted into ordinary shares at some point in the future Warrants are issued by the company and are not classed as shares but give the right to buy ordinary shares at a fixed price at some future date Companies will normally pay a dividend twice a year. At a point sometime before dividend is paid the shares will become ex dividend or XD. Anyone buying the shares when they are XD will not receive the next dividend but the person who sold the shares will receive it. When shares go XD the price normally falls to reflect the loss of income. 10

11 Rights issues A company will sometimes seek to raise capital by issuing new shares. This is called a rights issue. It offers existing shareholders the right to buy new shares at a discount. For example a company's shares may be trading at 120p and they offer each shareholder the right to buy one share for every four they hold for 60p. The shareholder can do one of three things. They can exercise the right to buy the shares They can decide not to exercise the right They can sell the rights Alan has 1000 shares. On the above basis he would have the right to buy 250 new shares at a cost of 150. When the rights issue is complete the number of shares will have been increased by 25%. In Alan's case he will have 1,250 shares which have a value of 1,350 (1,000 x 120p x 60p). This gives a price of 108p. Brian decides not to exercise the right. Because more shares have been issued his holding has been diluted. He owns less of the business than he did before. If he held 200 shares before the rights issue his holding would have been worth 2,400. After the rights issue, assuming the price was 108p, the total value would have been worth 2,160. Carol decides that she doesn't want to exercise the right but decides to sell her rights on the open market. Rights issues are normally underwritten. There is a risk that existing shareholders will not take up the offer so for a fee the company will get other financial institutions to agree to buy up any of the new shares that aren't taken up by the existing shareholders. A fee is charged for this. Share Analysis The price of a share is set by supply and demand in the market. Share analysis looks at data around the share itself to see if it represents good value. There are two key figures from which, together with the share price, we can derive useful data. These are: Earnings per share (EPS) Dividend. A company exists to make profits and as the shareholders are the owners they expect to be rewarded by receiving part of the profits as a dividend. EPS represents the profits or earnings that are attributable to the ordinary shareholders. It is not necessarily the same as the gross profits. For example if a company makes 10m in profits but has to pay the Bondholders 2m in interest then the profit attributable to shareholders is 11

12 8m. If there are 40m shares in issue then the EPS is 8m/40m = 20p. In other words each share has got 20p of profits behind it. Let s look at this in practice. Here are three companies all in the same sector. A B C Share Price 321p 340p 236p EPS From this we can calculate an important figure the price earnings ratio (p/e) The formula is share price/eps so in this case it will be: A B C Share Price 321p 340p 236p EPS p/e Calculation is one thing, interpreting the figures is another! All assets other than cash will fluctuate in price. If they produce an income one way in which we can assess their value is to compare its price with the income it produces. For example an investment property might produce 26,000 in income. If it is bought for 260,000 the price would have been 10 times its income. If it was sold for 520,000, it would have been sold for 20 times its income. The p/e of A is which means the market is prepared to pay a multiple of of its EPS for the shares. With company C it is only prepared to pay 9.52 times its EPS. What can be deduced from this? The usual answer is that a high p/e indicates a greater confidence in the future profits of the company whereas a lower p/e tends to indicate less confidence. Just by looking at the p/e it would seem to indicate that the prospects for A are better than C. Alternatively another analyst might conclude that A is overvalued and C is undervalued! P/E is useful but it needs to be treated with caution. The EPS of a company reflects its latest profits which are by definition historic. The share price is a current figure that changes minute by minute. Let s say that company B issued a profits warning and its share price slumped to 240p. The EPS would stay the same until the next profit figures were calculated but its p/e would have reduced to 240/32.73 or A variation on the P/E ratio is the Price Earnings Growth or PEG ratio. The formula is: Price Earnings ratio/anticipated growth so if the PE is 14 and growth is 7% the PEG is 2. If the PE is 8 but the growth is 2% the PEG is 4. 12

13 In general the lower the PEG the better. Basically the lower the number the less you pay for each unit of potential growth. Companies could pay out all the EPS as dividend but in practice they will only pay out a part of it and retain the remainder to invest in the business. A B C Share Price 321p 340p 236p EPS p/e Dividend 14.76p 16.9p 12.15p The next thing we can calculate is the dividend yield which is the dividend/share price expressed as a percentage A B C Share Price 321p 340p 236p EPS p/e Dividend 14.76p 16.9p 12.15p Yield 4.6% 4.97% 5.15% This tells us what return the dividend is paying and naturally we would like to see this as high as possible. It also gives us a comparison with other investments. As with p/e it needs to be treated with caution since dividend is historic and share price is current. A fall in the share price would increase the yield but one reason for the fall could be a profits warning and this would probably lead to a cut in the dividend. The ability to sustain dividend is a key factor in identifying share value and can be measured by dividend cover. This is EPS/dividend. A B C Share Price 321p 340p 236p EPS p/e Dividend 14.76p 16.9p 12.15p Yield 4.6% 4.97% 5.15% Cover In this case A is paying almost all its profits out as dividend and this may not be sustainable. B and C would appear to have a cushion so it is more likely that dividends will be maintained. In assessing dividend cover the higher the number the better. 13

14 Buying and selling shares Traditionally shares were bought and sold through stockbrokers. Today individual investors will normally use the stockbroking services of a bank or other financial institution. Both sale and purchase will usually incur a commission charge which for small trades will isually be a fixed fee. A purchase but not a sale will also incur stamp duty. This is 0.5% but the actual charge will depend on whether the transaction was done electronically using the CREST system or with a stock transfer form using a paper certificate. Purchases using the CREST system will be rounded up to the nearest 1p. This is termed Stamp Duty Reserve Tax (SDRT) Purchases using a stock transfer form will be rounded up to the nearest 5 but if the charge is less than 5, no duty is payable. This would be the case if the purchase was less than 5,000. This is termed Stamp Duty. In addition there is a possible Panel of Takeovers and Mergers (PTM) levy which is a flat charge of 1 applied to all trades of more than 10,000. Employee shares schemes There are two main types. Share Incentive Plans Share save Share Incentive Plans These can be free shares where the employer can give up to 3,600 of shares in any one year. There is no income tax on NI on this although they must be kept for five years to keep this tax free status. They can be withdrawn earlier without penalty in the case of retirement or redundancy. Employees can buy partnership shares buying shares out of gross income before tax and NI. The maximum is the lower of 10% of gross salary and 1,800. Again you must keep them for five years to be exempt from income tax and national insurance. A company may give matching shares which are limited to two shares for every one partnership shares. Dividends from partnership and free shares can be reinvested in Dividend shares. These must be kept for at least three years to be exempt from income tax. If the shares are sold whilst held in the SIP there is no Capital Gains Tax no matter how large the gain. If they are taken from the plan and sold later, CGT will be payable. 14

15 Sharesave schemes The employer will launch a scheme that gives employees the right to buy shares at a fixed price in the future. The employee can save up to 500 a month out of net salary for a period of three or five years. This is placed into a Save as You Earn (SAYE) deposit account. Interest is paid with no tax deduction. At maturity date the employee can exercise the option if the option price is below the current share price. Put another way the shares are bought at a substantial discount. They can then be sold for a profit or kept for future growth If the share price is below the option price it will not be exercised and the employee can take the value of the fund in the SAYE account When the shares are sold they are subject to Capital Gains Tax, the acquisition price being the option price that you paid. CGT can be avoided if they are transferred into an ISA or Pension as soon as they are purchased. 15

16 Property Property investment can range from someone letting out a room in their house to a multi million property company The basic return on an property investment is the rental income In addition the value of the property may rise giving a profit when it is sold. Taxation Rental income (to an individual) is classed as Non Savings Income and taxed at either 20%, 40% or45% Costs of running the property (insurance, management fees) can be offset against the rent) Interest on any borrowing to purchase the property can be offset against rental income. You cannot offset capital repayments. This though will be restricted to relief at basic rate in the future. This will be phased in from 2017/18 When property is sold, it will be subject to CGT. This is taxed at either 18% or 28% compared to the normal rates of 10% or 20% At the bottom end of the scale there is rent a room relief which allows someone to let a room in their house and get up to a week( 4,250 pa) tax free Stamp duty is payable on purchases. The rates aren t in the tax tables so should be memorised. The rate is tiered so for a property with a purchase price of more than 1,500,000 four rates of tax would be payable. Purchase Price Rate Maximum price at Tax payable on this band maximum price Up to 125,000 0% Next 125,000 1% 250,000 2,500 Next 675,000 5% 925,000 36,250 Next 575,000 10% 1,500,000 93,750 Anything above this figure 12% If the property is not the purchaser s main residence (including buy to let) these rates are increased by 3%. Purchase Price Rate Maximum price at Tax payable on this band maximum price Up to 125,000 3% 125,000 3,750 Next 125,000 4% 250,000 8,750 Next 675,000 8% 925,000 62,750 Next 575,000 13% 1,500, ,500 Anything above this figure 15% 16

17 Risks If there is no tenant there is no rent. A serious problem if money has been borrowed to buy the property. Whilst not strictly a risk, there are high costs involved in purchase, sale and running an investment property Property is illiquid in that it takes time to sell Property prices can also fall Property is therefore subject to capital and income risk Rewards Potential rising rental income Potential increase in capital value The main measure of return is the Gross Rental Yield. The formula is: Gross rental yield less expenses/acquisition price + costs of purchase On the top line any mortgage interest should be excluded. Commodities These comprise all physical assets that are traded on a regular basis. For individual investors the only one that is likely to be held on a physical basis is gold. Apart from the difficulty in holding other commodities as a class they have a number of disadvantages. They produce no income Prices can be highly volatile. Investors can get exposure to commodities indirectly by buying shares in mining and oil companies and collective products that invest in these. 17

18 Alternative Investments These are items such as antiques, paintings, high quality wine They can produce spectacular gains but there are a number of serious disadvantages They do not produce income Difference between buying and selling prices is usually high Price is subject to changing taste and fashion There are high costs of acquisition and disposal together with high costs in maintaining and insuring the item 18

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