Fixed Interest Stock
A Fixed Interest Stock is effectively a loan to the issuer (e.g. the British Government, in the case of a Gilt) from the purchaser. The loan must be repaid in full at the end of a predetermined term. In the meantime, interest is paid at a fixed rate on specified dates. Payments are usually annual, or semi-annual.
The repayment date on a Fixed Interest Stock is termed the maturity date. The price of stocks with maturity dates a long way into the future will rise and fall substantially in value as the prevailing long-term interest rate falls and rises. For example, if a new issue of £1,000,000 pays interest at 5% per annum and matures 20 years hence, and the market interest rate immediately falls to 4% per annum, then a willing purchaser will be willing to pay substantially more than the original purchase price of the stock, because it only requires a return of 4% per annum. In this example the purchaser should be willing to pay £1,137,000 for the stock giving the original owner a capital profit of £137,000. Similarly, if the prevailing interest rate rose to 6%, a prospective purchaser would be willing to pay less for the stock, because it requires a higher rate of return than that inherent in the original issue. In this example, the purchaser would pay £884,000, giving a capital loss of £116,000 to the original owner.
The further away the maturity date is, the more a stock will rise, or fall, for any given change in interest rates. Accordingly, longer duration stocks are more volatile in relation to interest rate movements than shorter duration stocks. This is a risk any purchaser of Fixed Interest Stocks takes, irrespective of the issuer. It is, of course, only a risk if the stock is not being held to maturity. If it is held to maturity it will always produce the yield inherent in the terms on which it was originally purchased.
If held to maturity the yield inherent in the market price of a stock at any time is generally termed the 'gross redemption yield'. At issue the gross redemption yield will simply be the interest rate on the stock. When a stock is later traded above, or below, its original issue price, the gross redemption yield will include not only regular income, but, also, an element of capital appreciation, if the stock is bought below the original issue price (generally called 'par'), or capital depreciation, if it is bought above par.
UK Government Stocks (Gilt Edged Securities or Gilts)
These are simply Fixed Interest Stocks issued by the UK Government. This means that they carry the highest level of covenant in terms of interest and capital payments. They are generally regarded as absolutely secure in this respect.
The market in these stocks is massive and can be traded at very low cost on instantaneous known prices in very low buy/sell price ranges (called 'price spreads'). The term generally used to describe this situation is that, the stock, and the market in which its trades, is highly 'liquid'.
Income payments under Gilt Edged Securities are taxable as investment income. There is no capital gains tax on Gilts. At first sight, this appears to be a benefit and, indeed, it used to be so when prevailing interest rates were high and many Gilts stood below par. However, with falling long-term interest rates, most Gilts stand above par, which means that a purchaser who buys and holds to redemption will experience a capital loss upon which no tax relief can be obtained. This makes such stocks comparatively more attractive to non-tax paying pension schemes than to tax paying private individuals.
These are Fixed Interest Stocks issued by companies. Accordingly, a Corporate Bond carries with it the added risk of default, if the company fails to honour the payments due. Reflecting this, purchasers of Corporate Bonds require a higher rate of return than those purchasing Gilt Edged Stocks of similar maturity duration. The extra return required is generally called the "spread" versus gilts, or, sometimes, just the 'yield spread'.
Anyone purchasing Corporate Bonds should not only investigate the covenant of the company concerned, but, also, where the Corporate Bond sits in the company's liability pecking order and what, if any, protections are wrapped around it. Not all bonds issued by the same company will have the same level of security behind them.
There are ratings agencies (the most notable being Standard & Poors, Moody's and Fitch) who apply ratings to the covenant of companies and the Fixed Interest Stocks they issue. UK Government issues are graded AAA. Corporates rarely achieve this grade, AA+ is usually their highest credit rating. Ratings go right down to C level. Once they start to move below BBB status, they are generally termed 'Junk Bonds'. They carry much higher yields than Gilts and high quality Corporate Bonds and are very much for speculators.
Most Corporate Bonds issued in the UK are known as qualifying Corporate Bonds. If they have this status they receive the same tax treatment as UK Gilts.
The market for Corporate Bonds in major companies is fairly liquid. However, price spreads amongst those institutions making the market are generally wider than those which apply to Gilts. The market in Corporate Bonds for smaller companies can be highly illiquid and they can be very difficult to trade in large quantities at reliable prices.
Zero Coupon Bonds
Occasionally, a Government, a Supranational body, (e.g. the World Bank), or a company, will wish to raise money on which it will pay no regular interest. The purchaser is rewarded with a much higher payment at maturity. Such bonds are called 'Zero Coupon Bonds' (they are, sometimes, just called 'Zeros').
Since they are issued at a price below the ultimate maturity value, they are said to be issued at a 'deep discount'. The gross redemption yield can be readily calculated by comparing the expected gain with the maturity duration. Since such stocks bear no interim interest payments, a Zero Coupon Bond with a given maturity date will be more volatile with regard to market yield movements than a Fixed Interest Stock of similar duration.
The UK Government does not actually issue Zeros. However, it does allow its normal Fixed Interest Stocks to be stripped into their constituent parts. They are called 'Gilt strips', or just 'Strips'.
The rate of return on such stocks is generally taxed as income. For Gilt strips, the calculation is done every year, irrespective of whether the stock is sold. There is, therefore, a negative cashflow to a holder. For Zero Coupon Bonds issued by companies and Supranational bodies, the taxation arises on maturity or disposal. If a disposal is made prior to the maturity there may be an element of taxable capital gain, or relievable capital loss, due to interim interest rate fluctuations.
Considerations regarding the covenant of an issuer are identical to those for a normal Fixed Interest Stock. However, it's needs to be borne in mind that, since no payment is made until maturity, the anticipated return is entirely dependent upon the issuer's financial status at that time.
An Equity share is an ordinary share of a company. It usually carries with it the voting rights which in aggregate control the conduct of the company. The original investor buys newly issued shares and the purchase price becomes the capital of the company. Companies can issue further Equity shares at later dates on terms reflecting market conditions. Companies can decide to pay dividends on Equity shares. The rates of dividend are entirely a matter for the company's board to determine and can rise, or fall, on a year by year basis. Dividends come out of net profits, or reserves, but carry with them a small tax credit.
Equities are not redeemable and have no maturity date. Companies can buy back their own Equity and, if a company is wound-up, the residual assets, after all creditors and preferential interests are satisfied, are distributed amongst the Equity shareholders.
The main ways an investor obtains a return on an Equity are by:
. Receiving dividends whilst holding it
. Selling it at a profit
Of course, an Equity may also be sold at a loss, if the state of the market in general, and/or the company in particular, dictate that a lower price prevails.
In general, the market in Equities is a much less technical one than that which prevails for Fixed Interest Stocks which are dominated by interest rate/yield changes. Major Equities are traded in highly liquid markets, although price spreads are generally much greater than for the highest quality Fixed Interest Stocks. Second line and small company Equities trade in much less liquid markets and price spreads can be very wide, especially for those trying to dispose of substantial holdings.
Preference Shares are issued by companies and, like Equities, they pay dividends out of company profits. However, the dividends are fixed. Unlike Fixed Interest Stocks, which have an obligation to make interest payments, they can only pay dividends when there are available profits, or designated reserves, from which to do so. The terms 'Preference' simply means that they take preference over Equity shares in the payment of dividends and the repayment of capital on the wind-up of a company.
Preference Shares may be redeemable, if this is specified by the original issuing documentation. They can only be redeemed if adequate reserves are available at the relevant time. There may be numerous different issues of Preference Shares and, in a conglomerate, the issues may come from different parts of the group and have different covenants and expectations. They always require the most careful research before acquisition. Given that they carry considerably greater risks than Corporate Bonds, they would be expected to produce a rate of return, based on the specified level of dividend, well in excess of that available on Corporate Bonds issued by companies of similar covenants.
In a situation where a company fails to meets its obligations under a Corporate Bond, the bondholder generally acquires creditor, and, sometimes, preferred creditor status. If a payment fails to be made under a Preference Share, it is because the conditions for that payment (i.e. available reserves/profits) are not met. The Preference Shareholder does not, in these circumstances, have any creditor rights.
Some Preference Shares are cumulative. This means any dividends which cannot be paid are accumulated for payment later, if conditions permit. Others are non-cumulative, so, a dividend which has to be passed is lost.
The market in Preference Shares is generally highly illiquid with wide price spreads. The return proposition they offer is so far away from that of a Gilt Edged Stock that they do not behave predictably with regard to market interest rate/yield fluctuations. It would be entirely possible to see long-term interest rates falling (and hence, Gilt Edged and high quality Corporate Bond prices rising) whilst Preference Share values fall due to a perceived greater level of risk of non-payment of dividends, or capital redemption.
Zero Coupon Preference Share
This is simply a Preference Share which has no entitlement to dividends. It will be redeemable at a specified date at a predetermined figure. The investor is reliant upon the company having adequate reserves at the redemption date. The interest rate volatility is increased by the absence of any interim return and the risk of loss is pushed further into the future. It is also often termed a 'Zero', but should not be confused with a Zero Coupon Bond which has different characteristics.
This is a limited company set-up specifically to invest in specified markets. Unlike Unit Trusts and OEICS, there will be a limited number of shares in issue and they change hands just like Equities on the stock market. Again, just like any other company, the Investment Trust is able to borrow. Sometimes, borrowing powers are limited by its constitution. Unlike Unit Trusts and OEICS, the share price of an Investment Trust may be at a discount, or premium, to its underlying net asset value. This is simply due to the forces of supply and demand and the perceived level of quality inherent in the underlying investments and the management of the trust. Given the ability of an Investment Trust to borrow, its returns and risks can be geared. This is in contrast to the Unit Trust, or OEICS, where borrowing is not permitted. The liquidity of any given Investment Trust varies dependent upon size and market perception. Straightforward Investment Trusts are generally quite actively traded.
Split Capital Trust
This is an Investment Trust in which hybrid shares have been issued. There is usually a pre-specified wind-up date for the company. Rather than having straightforward Equity and Preference Shares, there are two or three different classes of share with very different characteristics:
. Zero Coupon Preference Shares have a right to a predetermined return, provided there are available reserves at the specified redemption date. Whilst it seems likely that the predetermined return will be achieved, they have a tendency to behave like Zero Coupon Bonds, but with a yield reflecting the level of security they offer. However, when it appears the redemption figure may not be available from reserves at the maturity date, they will behave differently. Their performance will be determined by the underlying assets (usually Equities), liabilities (usually bank debt) and prior calls on income (usually from bank interest, Ordinary Shares and expenses).
. Ordinary or Income Shares have the first right to income from the investments of the trust. These shares stand behind the maturity proceeds on Zero Coupon Preference Shares when the trust is ultimately wound-up.
. Capital Shares are not always issued in Split Capital Trusts. Where they are, they are entitled to any residual capital left after obligations to Zero Coupon Preference Shareholders and Ordinary Shareholders have been satisfied when the trust is wound-up.
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