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AF4: Investment Planning Overview and asset classes

AF4: Investment Planning Overview and asset classes. Tax year 2019/20 John Trayner FCII FPFS. What makes AF4 challenging?. Big jump from R02 Questions may focus on areas that you may not normally come across in your work The questions on each paper tend to vary widely from exam to exam.

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AF4: Investment Planning Overview and asset classes

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  1. AF4: Investment PlanningOverview and asset classes Tax year 2019/20 John Trayner FCII FPFS Audley Financial Training

  2. What makes AF4 challenging? • Big jump from R02 • Questions may focus on areas that you may not normally come across in your work • The questions on each paper tend to vary widely from exam to exam Audley Financial Training

  3. What makes AF4 challenging? • Big jump from R02 • Questions may focus on areas that you don’t normally come across in your work • The questions on each paper tend to vary widely from exam to exam • However it’s possible to identify four key subject areas Audley Financial Training

  4. The big 4 An understanding of how we define, measure and control risk A deep understanding of the main assets classes and how we can establish value An understanding of the different methods of evaluating performance An understanding of the main investment strategies and investment products Audley Financial Training

  5. Day 1 objectives • By the end of the event delegates will be able to: • Identify the characteristics and risks of the main asset classes. • Accurately calculate and interpret the main performance measures of a Bond • Accurately calculate and interpret the main performance measures of shares • Accurately calculate and interpret the primary financial data in a company’s balance sheet and accounts • Understand how economic factors can affect the performance of different assets. Audley Financial Training

  6. Day 1 objectives (continued) • Understand and analyse an asset’s Standard Deviation and Beta • Calculate accurately the output of the Capital Asset Pricing Model and explain its limitations • Explain the differences between systematic and non-systematic risk • Explain the concept of the Efficient Frontier • Explain how correlation is measured. • Understand the principles of Modern Portfolio Theory • Understand how economic factors affect different investment classes Audley Financial Training

  7. Part 1: Asset classes • The basic building blocks of all investment products • A deep understanding of the characteristics of each is the basis of the knowledge required for AF4 • A financial asset is anything that can produce an income and/or has the potential to grow in value Audley Financial Training

  8. “Periodic Table” of assets Audley Financial Training

  9. Cash • Main things to know are mathematical calculations: • Compounding • Discounting • Rate of return • GET A SCIENTIFIC CALCULATOR AND KNOW HOW TO USE IT! Audley Financial Training

  10. Compounding FV = PV(1+r)t £10,000(1+ 0.042)5 £10,000(1.042)5 Current value (PV) is £10,000 If the return (r) is 4.2% What will be the future value (FV) be in 5 years time (t) £10,000 x 1.228 £12,283.96 Audley Financial Training

  11. Discounting PV = FV (1+r)t £60,000/(1+ 0.035)10 £60,000(1.035)10 Target value (FV) is £60,000 This is needed in 10 years time (t) If the return (r) is 3.5% What do you need to invest today (PV) £60,000/1.411 £42,523.03 Audley Financial Training

  12. What was the return? (£36,000/£30,000)1/6 - 1 R = (FV/PV)1/t – 1 (£36,000/£30,000)0.167 -1 Starting value (PV) is £30,000 It was invested for 6 years (t) End value (FV) is £36,000 What was the rate of return (r) 1.2 0.167 – 1 1.031 – 1 = 0.031 x 100 = 3.1% Audley Financial Training

  13. Returns on cash • Interest by lending money to banks/building societies or Government though National Savings • Peer to Peer lending • Holding non UK currency Audley Financial Training

  14. Money Market “near cash” assets • Short term instruments • Usually wholesale rather than retail • Primary use is to provide liquidity for Government and Banks • Treasury Bills, sold at discount to redemption value • Certificates of Deposit issued by banks • Commercial Bills issued by companies Audley Financial Training

  15. Bonds Audley Financial Training

  16. What we’ll cover • The basic concept of Bonds • What determines the market price of Bonds • What Bonds can give investors • How to calculate Gross Yield to Redemption • Yield curves and their importance • Sovereign debt v Corporate Bonds • Bond duration, what it is and what it means • Indexed linked Bonds Audley Financial Training

  17. Fixed rate investments A fixed rate investment does what it says on the tin. The borrower promises to pay the lender an interest rate that cannot be altered All Bonds are fixed interest investments But not all fixed rate products are Bonds Audley Financial Training

  18. You can have it but we will charge you 90 days interest That sounds good but what if I want to get my money back before the end of the term? We have a 3 year account paying a guaranteed rate of 2.5% Audley Financial Training

  19. For every £100 you lend me I will pay you £2 every 6 months and repay the £100 in 2038 I need to borrow and am prepared to pay 4% and repay this in 2038 Audley Financial Training This Photo by Unknown Author is licensed under CC BY-SA

  20. Not from me! I will only pay you back in 2038 but you can sell the debt on the secondary market That sounds good but what if I want to get my money back before the end of the term Audley Financial Training This Photo by Unknown Author is licensed under CC BY-SA

  21. Primary and secondary market The owner can sell the bond on the secondary market. They receive the cash and the Bond issuer pays all future interest to the new owner The borrower issues the Bond and receives money from the original investors The Bond issuer repays the original loan to whoever owns the bond on redemption date Audley Financial Training

  22. Pricing debt • Everything we buy has a unit price • £/kg, £/litre, £/metre • Debt traded on the secondary market is priced in £x per £100 of debt (or xp per £1 of debt) • The interest rate (aka the coupon) and the redemption date are fixed. • The one variable is the market price • But the price will always revert to £100 at redemption date Audley Financial Training

  23. Anatomy of a Bond The date on which the original loan will be repaid together with the final interest payment Coupon The fixed rate of interest that will be paid Name. This will usually include the year of repayment and the coupon The market price. The price you have to pay for £100 of debt Audley Financial Training

  24. Buying the 2028 issue • Coupon is 6%, market price £143.20 • An investor wants to purchase £100,000 of this to produce a gross income of £6,000. • This will cost £100,000 x 143.2% = £143,200 Audley Financial Training

  25. How does the coupon compare to current interest rates and inflation? Old Bonds for sale! How financially strong is the borrower? What is the remaining term of the Bond? Audley Financial Training

  26. Effect of interest rate changes Today you should get more than £100 because interest rates are lower than 5% so the price will be higher I want to sell it so will someone pay more or less than £100? I have a bond maturing in 10 years time with a coupon of 5% Audley Financial Training

  27. Effect of issuer’s financial strength • Dodgy Business PLC has a Bond with a coupon of 8% maturing in five years. • It is struggling financially. • There is concern it may default on this Bond. • The market price is likely to be well below £100 • The potential return could be high since if it doesn’t default the holder will receive £100 in five years time Audley Financial Training

  28. Effect of remaining term • At redemption date the Bond issuer will repay the debt. • Therefore the price will move back to £100 as redemption date moves closer. • The market will ensure that capital loss on redemption will not be more than the future income that will be received. • A Bond with a coupon of 5% and three years to run will produce £15 of future income. • The market price should not go above £115 Audley Financial Training

  29. What Bonds can offer investors • They give a fixed income. • Investors can accurately calculate the return they will get. • They can offer a hedge against interest rate movements • BUT • Inflation reduces the real value of both income and the capital repayment. • They cannot give an increasing income • When the Bond is repaid an investor must find a new investment and may find current bonds have a lower coupon Audley Financial Training

  30. Certainty of return: Bond held to redemption If I keep the bond until its expiry I will receive £40,000 in interest plus the return of my £100,000 In other words, as long as the borrower doesn’t default, I know exactly what I’m going to get I’m going to invest £100,000 in a new issue Bond paying 4% for 10 years Audley Financial Training

  31. Certainty of return: second hand Bonds • If the bond was purchased for £125, (£125 for £100 debt) the investor will still get £5 a year for every £100 of nominal debt • However they aren’t getting 5% because they paid £125 to get an annual income of £5 • Plus if they keep it to maturity they are bound to lose £25 • The return will be a combination of the interest they will receive plus or minus the difference between the purchase price and the redemption value of £100 • This return can be expressed as a percentage Audley Financial Training

  32. Different Bond types • Sovereign Debt: Bonds issued by Governments • Gilts: Bonds issued by the UK government • Corporate Bonds: Bonds issued by companies Audley Financial Training

  33. Key returns • Running or Daily Yield • The yield expressed as a percentage of the coupon over the clean price • Gross Yield to Redemption • The yield taking into account the gain or loss if held to redemption • Net yield to redemption • As above taking into account the holder’s tax situation Audley Financial Training

  34. Clean price v Dirty Price Gilt with 6% coupon pays out 7 December and 7 June On 7 March it is sold for £125 The seller requires the buyer to pay an additional £1.50 being the accrued interest On 7th June holder will receive £3 £3 £125 is the clean price £126.50 is the dirty price 7 December 7 March 7 June Audley Financial Training

  35. Running Yield • Holder paid £143.50 for £6 a year income for 10 years • Formula is Coupon/Clean price • Therefore running yield is £6/£143.50 x 100 = 4.18% Audley Financial Training

  36. Gross Yield to redemption Holder will receive £100 on December 7 2028 Therefore guaranteed to lose £43.20 if held to redemption Audley Financial Training

  37. How to calculate GYR • Calculate daily or running yield by dividing coupon by clean price • £6/£143.50 x 100 = 4.18% • Calculate loss and divide by years to redemption • £43.50/10 = £4.35 • Divide this by clean price • £4.35/£143.50 x 100 = 3.03% • Subtract this from running yield • 4.18% - 3.03% = 1.15% Audley Financial Training

  38. Net Yield to redemption • Interest is taxable but gain or loss is tax free/not deductible. • NYR is the same formula as GYR but using coupon after tax • A bond has a coupon of 4.25%, price £130 (assume 10 years to redemption) • A higher rate taxpayer receives a net coupon of 2.55% • 2.55/130 = 1.96% • 30/10 = £3; £3/£130 = 2.31% • 1.96% less 2.31% = -0.35% Audley Financial Training

  39. Prices and Gross Yields Price rises Yield Rises Yield Falls Price falls Audley Financial Training

  40. Treasury 4 ¾% December 2038 Audley Financial Training

  41. Why Gross Yield to Redemption is important • High demand for a Bond will increase its price and reduce its yield. • Bond investors tend to focus on GRY. Does it meet their needs and is it worth paying the market price to get that yield • Since UK Gilts have virtually no default risk, the GRY for any given term represents an almost risk free return. • Therefore it would be irrational to invest elsewhere if the Bond yield met the investor’s requirement. • Or the investor has to take additional risk if they want a higher return • It also indicates the rate at which Government can borrow Audley Financial Training

  42. Yield curves Normal Curve. The YTR increases as the term increases Level Curve. Yields broadly the same whatever the term Gross Yield to Redemption Redemption date Inverse Curve The YTR reduces as the term increases Audley Financial Training

  43. Inverse curve: the canary in the coalmine? Research in the US suggests that an inverse yield curve is an early indicator of a recession Audley Financial Training

  44. Why the yield curve inverts Investors fear equities are too volatile, or returns will fall. Long term bond yields look attractive as they can lock in future returns. Demand increases and prices rise so yields fall Short term interest rates are rising, or investors fear they will rise. Coupon becomes less competitive so demand for short term gilts fall. This pushes down prices and increase yields Audley Financial Training

  45. Inverse Curve: A red flag? • Investors are switching from equities into more secure gilts because of fears of an economic downturn. • Interest rates are predicted to fall in the short term which pushes up the demand for higher coupon gilts. • There is a high demand for longer term gilts from pension funds who look to balance their long term liabilities. • A normal curve will probably turn level before it becomes inverse Audley Financial Training

  46. Spreads • A measure of the difference in yields between different bonds. • Unit is “basis points” (BP) • This is 1/100th of 1 per cent • US 10 year Treasury GYR is 2.99% • UK 10 year gilt is 1.36% • Therefore the spread is 1.63% or 163BP • In this example a comparison is made between two issuers and the same maturity date Audley Financial Training

  47. More spreads • The spread of yields between different terms of the same issuer can also be made • The yield of a 10 year UK gilt is 1.34% • The yield on a 20 year gilt is 1.87% • The spread is 53 BP • The yield on a 30 year gilt is 2%, a spread of 13BP on the 20 year and 66BP on the 10 year Gilt • A lowering of the spreads would indicate that the yield curve is flattening Audley Financial Training

  48. Widening or narrowing • GYR are constantly changing therefore the spread between two bonds will also vary. • They may narrow, the yields become closer, or widen. • A widening spread may mean that one bond is seen as being more risky than the other. • Bond A has a higher YTR than Bond B with a spread of 150BP • The spread rises to 270BP which could indicate that the credit risk of A has increased Audley Financial Training

  49. Non UK sovereign debt • Government bonds issued by other countries • Credit rating of country will affect coupon and GRY • Specific issues in Eurozone countries as bonds issued in euro and unlike UK cannot “print” money • Countries can default but bondholders have no claim on the country’s assets. Audley Financial Training

  50. Corporate Bonds • Issued by companies to raise capital • Greater risk than Sovereign Debt as subject to default risk • Credit rating agencies will assess risk • The higher the risk the higher will be the coupon and the GRY • Also term tends to be shorter • In theory bondholders can claim on assets of a defaulting company Audley Financial Training

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