Investment in single company shares and gilts - Coursework Example

of the of the AFA work Investment in Single Company Shares and Gilts PART A: Introduction The dictionary defines the term Investment as ‘the commitment of money or capital to purchase financial instruments or other assets, in order to gain profitable returns in the form of interest, income, or appreciation of the value of the instrument’ (www.yourdictionary.com). From the point of view of economics, the act of investment is related to saving or deferring consumption today for the purpose of a better or higher return tomorrow. Interest is the price paid to the investor for waiting or deferring consumption. As consumers, we may invest for a number of reasons. We may invest in a house because we want the comfort of a shelter and a place to hold our belongings, a car to drive us to work, or a beach house to spend the holidays. Investments are also made in financial instruments that have value such as shares, bonds and pension plans. The idea is that the investment should bring us a better level of return in the future. Investments may also be made by corporations of monies kept for the purpose of buying future assets or replacement of machinery etc. The investment made in different types of financial instruments will yield a rate of interest and may increase or decrease in value due to demand and supply or various other factors. Thus investment will give one more than one types of return- interest earned and capital gains. The Investment Climate in the UK The UK has a very active financial environment, as London has been one of the most important financial centers of the world for some time now. The main reasons for this are the availability of infrastructure in the shape of the equity and bond markets and money market for local and foreign currencies. The main offices of the Bank of England, the UK’s central bank and many other local and international banks are housed here too, much like Wall Street in New York, USA (Kindleberger, 17). There are thousands of trades done daily on the floors of these banks and exchanges. These trades are directly or indirectly related to trade and commerce and the flow of goods, services and money from one bank or country to another (Ross, 12). The activities in the equity and bond markets may be of primary or secondary nature. Primary activity means the issue of new shares or bonds, and secondary activity means the trading or reinvestment of previously issued shares or bonds. Under the corporate form of ownership, a company can raise capital from the general public by issuing a Prospectus in the newspaper stating the nature of its intended business, and viability and profitability of the same. It is left up to the general public to judge and decide for themselves whether or not to invest in the shares or ownership rights of the business. This is called an Initial Public Offering or IPO if the company is inviting the public to purchase its shares for the very first time. The same activity may be carried out in the bond market which is the market for the issue and trading of debt securities. Bonds signify the debt of a company, and the owners of bonds are called the creditors of the company. Previously issue bonds can also be re-bought or resold at the rates prevailing in the market. Bond and equity markets always travel in the opposite directions. If the equity market is up, the bond market would be down and vice versa (Thau, 3). While the owners of bonds, debentures or debt securities are assured an interest payment at a defined rate of interest, and the price of the market value of their bonds at any time they decide to liquidate their holdings, the owners of equity shares will get a dividend payment based upon the number and value of shares they hold at that point in time. This is usually declared by the Board of Directors based upon the profits made by the company in a particular year. They are under no obligation to declare a dividend and may alternatively decide to plough back the profits into the company, to reinvest in new machinery or better technology. The investor in equity shares can also decide to liquidate his holdings by selling off his equity shares to another buyer at the prevailing price in the markets. The bond and equity markets offer the dual facility of attracting new capital or debt as well as the opportunity for the holders of bonds and shares to liquidate their holding at any time they want by making a deal with new buyers and accepting the prevailing market price for the value of their divestments. It must also be stated that buying and selling is based on perceptions in the mind of buyer and seller. Buyers generally accept that the value of the investment is going to go up- they buy with a view to holding on till this happens and they can liquidate the investment and profit their profits and capital gains. Sellers on the other hand want to sell off the investment to get ready cash or because they may be faced with a financial emergency requiring ready cash. A trade can be conducted when buyers and sellers meet. However it is generally seen that such trades in securities are conducted through a stock-broking firm. A stock broker or stock-broking firm is a person or institution authorized to deal in the buying and selling of securities on behalf of buyers and sellers, in exchange for a commission, which is a small percentage, typically 2-4% of the total sale or purchase price. The buyer or seller who contacts the stock broker gives him certain price parameters and time deadlines within which to execute the transactions. The stock broking representative on the floor of the stock exchange uses the open outcry method and a series of secret hand signals to indicate that he has accepted the transaction. A trade confirmation sheet is accordingly made out to the client showing the price contracted; volume of sales, commission etc. After this the stock brokers on the buy and sell side typically have between a week to two weeks to conclude the actual delivery of the shares and accept the monies etc. In modern exchanges, physical delivery of the shares is not necessary; simply a transfer of name indicates the sale and the new buyer or owner of the securities. The same thing happens in the bond market with regard to purchase and sale of debentures. We can generally judge the rate of activity in the stock market by the number of shares traded in a day multiplied by the market value of the shares. This is known as the Market Capitalisation. The more the market Capitalisation, the higher is the rate of activity in that particular exchange. As regards the trends, if the sellers are dominating the market and the market is losing value, there is a bearish trend. If the buyers are dominating the market, it signifies the market is gaining value and the trend is said to be bullish. There are a number of shares on every exchange that have dominated the proceedings and these are typically recorded in an index such as the FTSE100 for the UK. Accordingly the index for FTSE will go up or down depending on the trading in these stocks on a particular day. The same holds for other indexes. What is a Share? A share is the smallest piece of ownership in a corporation and it represents one voting right as well. Companies generally make out share certificates for a 100 shares at a time, recorded at their face value. Thus one share certificate for a 100 shares of XYZ Corporation would be in the amount of 100 x 10 = ?1,000, if each share was recorded at face value of ?10. It must also be kept in mind that the actual value of the shares at any given time after the initial offer would be their market price on the stock exchange. Thus the market price of gilt edged securities or the shares of financially strong or very well regarded and managed firms would be many times their face value. Sometimes the market value of a gilt edged security becomes very high and a company finding it difficult to raise further capital may decide on a stock split, in which the share certificate of 100 shares may be split into 5 share certificates of ?20 each. This aids the liquidity and trading of gilt edged securities, and the company can also invite offers for further capital investment in this manner. A reverse stock split, or a stock consolidation, would result if the capital is reconstituted into a lesser number of share certificates than before (Valdez, 36). Notwithstanding a share split or consolidation, the total face value of paid up capital would be the same. The only advantage is that in case of a stock split, it aids in the resale and marketability of the shares. Sometimes when the majority of stock ownership gets concentrated into undesirable hands, the company can even buy back its own capital in this way and label it Treasury Stock on the balance sheet (Grabbe, 37). What is a Gilt Edged Security? As already mentioned previously, gilt edged securities are extremely well regarded secure investment instruments. Specifically with regard to the UK, a gilt is a Government liability in Sterling, issued by Her Majesty’s Treasury and listed on the London Stock Exchange. The term gilt or gilt-edged security is a reference to the primary characteristic of gilts as an investment- namely, the reliability of value. This reflects the fact that the British Government has never failed to make interest or principal payments on gilts as they have fallen due (Choudhary, 139). The gilt market in the UK is essentially comprised of two different types of securities - conventional gilts and index-linked gilts – which account for around 99 percent of gilts in issue. Conventional gilts are the simplest form of Government Bond and constitute the largest share of liabilities in the Government's portfolio. Conventional gilts are thus a liability of the Government which guarantees to pay the holder of the gilt a fixed cash payment based upon a coupon every six months until the maturity date, at which point the holder receives the final coupon payment and the return of the principal. The prices of conventional gilts are stated in terms of the nominal value of ?100 on the exchange (Fabozzi, 23). In the UK, conventional gilts are denoted by their coupon rate and maturity (e.g. 4% Treasury Gilt 2014). The coupon rate reflects the market interest rate at the time of the first issue of the gilt. There may be a wide range of coupon rates available in the market at any one time, reflecting how rates of borrowing have fluctuated in the past. The coupon indicates the cash payment per ?100 nominal value that the holder will receive per year. This payment is made in two equal semi-annual payments on fixed dates six months apart. Payments are rolled forward to the next business day if they fall on a holiday. Conventional gilts also have a specific maturity date. In recent years the Government has concentrated on issuing conventional gilts around the 5, 10 and 30-year maturity areas (Fabozzi, 56). Compared to conventional gilts, index-linked gilts form the largest part of the gilt portfolio. In fact the UK was one of the first developed economies to issue index-linked bonds for institutional investors, the earliest issue being in 1981. As with conventional gilts, the coupon on index-linked gilt reflects borrowing rates available at the time of first issue. However, as index-linked coupons reflect the real borrowing rate for the Government rather than the nominal borrowing rate there is a much smaller variation in real yields over time (Fabozzi, 17). Index-linked gilts differ from conventional gilts in that the semi-annual coupon payments and the principal are adjusted in line with the UK Retail Prices Index. This means that both the coupons and the principal paid on redemption of these gilts are adjusted to take account of accrued inflation since the gilt was first issued. For issues prior to July 2002, the Bank of England performs the function of calculating and publishing the uplifted coupons on the index-linked gilt following the release of the RPI figure relevant to it. For index-linked gilts issued dated July 2002 and later the DMO performs this function (UK Debt Management Office). Each coupon payable on index-linked gilts consists of two elements: (1) Half the annual real coupon. The real coupon is quoted in the gilt's title and is fixed; (2) An adjustment factor applied to the real coupon payment to take account of the increase in the RPI since the gilt's issue (UK Debt Management Office). ALTERNATIVE INVESTMENT STRATEGIES: Deliberate Purchases over Time The decision to purchase the shares of a single company or a gilt edged security may be deliberate purchases over time. In fact this may be a person’s or a household’s individual strategy over their working life, as and when they received a windfall such as a bonus or increment, they decided to make such an investment. This is really a good thing to do. In fact since UK Government based indexed gilt edged securities are now adjusted for inflation as well using the RPI as just stated above, there is literally no risk associated with this investment, except the risk of the UK Government defaulting on its payment of interest or repayment of principal and that has not occurred so far. The only drawback of such an investment is that if the family ties up the majority of savings in this one investment, it may have to liquidate part of it in response to situations like marriage of children, college expenses or dire medical emergencies not covered under insurance or a medical plan as they get older (Goldberg, 26). Demutualisation of Companies and Other Windfalls Demutualisation occurs when a mutual company that was owned by its users or members is converted by agreement into a company owned by shareholders (Oxford English Dictionary online). The users or members here have exchanged their rights of use for shares in the demutualized company. A mutual company is generally created to provide specific services at the lowest possible price to benefit its users or members. A farmer’s cooperative would be a good example. As a result of Demutualisation, ownership of the mutual company is separated from the exclusive right to use the services provided by the company. Sometimes the Demutualisation enables the new owners or management to raise capital for new purposes, whereas this was not possible in the case of mutual ownership. The users or members can choose to raise capital on their own or sell out to a corporation for a price which then becomes a windfall for them. If this purchase price is paid for in terms of shares of a single company or via gilt edged securities, it is another instance where a group of individuals is so benefitted. They would accrue the same benefits and risks as the individual or family would face as given above (Massey, 33). Inheritances Received Another popular way in which one may come into the possession of shares in a single firm or gilt edged securities is through inheriting them through a benefactor who has bequeathed these investment instruments to the said individual. This is a very natural or normal occurrence and is usually seen in middle class to well-to-do families. Unfortunately the new recipient has to pay inheritance tax on them. For this purpose the shares and gilts would have to be valued on the day of death of the deceased party. We could use the services of a professional valuer, or calculate the value ourselves by taking the closing price of the shares from the financial section of that day’s newspaper. If the deceased held gilt edged securities, we will need to contact the Debt Management Office with a copy of the death certificate and they would do the evaluation for us free of charge (Website of the UK Debt Management Office). Tax Implications In both the UK and the USA, the sale of securities is liable to a capital gains tax. At present a basic amount of ?10,100 is exempt for 2010-11 on individuals as a tax free allowance proposed to be raised to ?10,600 for 2011-12. Exemptions also accrue to your car, your house and other possessions below the value of ?6,000 if they have not been used in your trade or for a particular length of time. Records that show the original cost of an asset and the market value or sale price as on the date of sale must be retained for the purpose of proving capital gains or losses. UK citizens are liable to file such returns within three months of the date of the sale (www.hmrc.gov.uk). Losses on disposal of assets can also be set against income earned subject to certain rules and guidelines within a specified time frame. Gilts are exempt from tax. There is however an inheritance tax on bequeathed items like shares. Above the exempted limit, capital gains tax can be levied at 18% and 28% depending on the sums earned as capital gains. An Alternative: Holding Securities in the Form of Collectives One way to diversify your investment holdings and hopefully reduce your losses is to hold securities in the form of collectives in the UK. Collectives are known by various other names in the USA such as mutual funds, managed funds, investment funds or simply funds. Collective investments are usually named after their founder, or sector of majority shareholdings, or even aimed at different regions of the world. Emerging markets funds were popular in Asia not so long ago. Collectives usually form a sector all by themselves in the stock exchange (Vishwanath, 3). The advantage of using collectives or mutual funds is that they are under the control of reputed fund managers with experience in selecting stocks for investment and return. Collectives may be open ended or closed ended, meaning that the stocks in the funds are either changeable or fixed. In terms of ownership possibilities, collectives may also be classified as open to the general public, open to limited entities based on size and volumes of investment, and limited to family members or employees of a specific organization, depending on who set up the fund and why. A fund can also have a specific end date, upon which the shares are liquidated and the proceeds shared among the shareholders or participants of the fund. Funds are usually quoted in terms if their net asset values. Collective investment funds are sometimes also split into different classes having different rights. For instance, funds sold through a broker or investment advisor and which attract a fee or commission are called Retail Shares. Funds sold directly to the public at the going rates without additional costs are called Direct Shares. Another group of collectives that are typically high priced or in larger volumes and sold only to institutions are called Institutional Shares. There has also been a move in recent times to invest in collectives under a retirement plan such as a Defined Contribution Pension, where a number of retirees can hope to gain the advantages of good returns where the cost and volume of the shares is split across the whole to get the advantages of economies of scale (Amin & Kat, 27). Among the advantages of using a collective or mutual fund type of investment is that the owners enjoy the benefits of diversifying risk and return, reduced cost to buy as the number and types of shares are already decided by the fund manager prior to offer. Among the disadvantages that the owners of mutual funds may be exposed to are the cost of maintaining the fund including the fund manager’s remuneration, cost of advice to see the makeup of the fund and the lack of control in decision making. The growth and value of the fund is forever beyond the control of a mutual fund shareholder. Some of the internationally recognized funds are called EFTs or exchange traded funds (open ended); sovereign investment schemes; REITs or real estate investment funds; collectives; and investment and unit trusts. Most of them are traded on the stock exchanges as well (Hennessey & Jeannet, 25). Conclusion This paper has compared the advantages and disadvantages of investing in single shares and gilts, discussed the different scenarios under which one may come in possession of them, and the rights and liabilities connected with each scenario whether it is a conscious and informed decision, through Demutualisation windfalls or through inheritance. It has also touched upon the alternative strategy in investing in a collective or mutual fund, professionally managed but where the investment selection and growth and value of investments is in the hands of a professional investor, which may not match the investor’s (Fabozzi, 1996). Obviously there is a cost to everything and in this case some degree of loss of control is inevitable. Works Cited Amin, G. & Kat, H. Stocks, Bonds &Hedge Funds. Journal of Portfolio Management, Summer 2003, p 113. All About Gilts. Website of the UK Debt Management Office. Accessed on 25 May 2011 at http://www.dmo.gov.uk/index.aspx?page=gilts/about_gilts Choudhary, M. Bank Asset and Liability Management: Strategy, Trading, Analysis. Wiley Finance, 2007. Definition of Investment. Accessed on 25 May 2011 at www.yourdictionary.com. Definition of Demutualisation. Accessed on 25 May 2011 from Oxford English Dictionary online. Fabozzi, F. Bond Markets, Analysis & Strategy. Prentice Hall, London, 1996. Fabozzi, F.et al (ed.) Active Asset Allocation. Irwin, London, 1996. Fabozzi, F. Bond Portfolio Management. Irwin, London, 1996. Fabozzi, F. Collateralized Mortgage Obligations. Irwin, London, 1994. Fabozzi, F. et al (ed.) Capital Markets. Prentice Hall, London, 1996. Grabbe, O. An Introduction to International Financial Markets. Prentice Hall, New Jersey, 1996. Goldberg, J. et al. Behavioral Finance. Finanz Buch Verlag, Munich, 1999. Hennessey, D. & Jeannet, J. Global Account Management: Creating Value. John Wiley & Sons, 2003. Kindleberger, C. A Financial History of Western Europe. OUP, 1994. Mahoney, S. Mastering Government Securities. Pitman, 1996. Massey, D. Introduction to New Issues, Pitman, 1996. Ross, D. International Treasury Management, 3rd ed. Amer Educational Systems. 1996. Thau, A. The Bond Book, Third Edition. McGraw Hill, 2010. Valdez, S. An Introduction to Global Financial Markets. Macmillan, NewYork, 1997. Vishwanath, R. & Krishnamurti, C. Investment Management: A Modern Guide to Security Analysis & Stock Selection. Springer, 2009. Website of the HM Revenue and Customs. Accessed at www.hmrc.gov.uk . Zimmerman, H. Asset & Liability Management. Neue Zurcher Zeitung, Munich, 1995. Annotated Bibliography 1. Choudhary, M. Bank Asset and Liability Management: Strategy, Trading, Analysis. Wiley Finance, 2007. For anyone who thinks that the theory and practice of banking is a boring subject, here is an eye opener and a very interesting read indeed. Though the book is quite voluminous at 1088 pages, it has been extremely well conceived and equally well written. In the modern era of the 21st century, banks have begun to play a very pivotal role in our lives and this book shows how much so. Even a cursory reader would be interested in the workings of a modern bank- it is a far cry from the days of old when banks were primarily deposit taking and lending institutions. The book starts off with the functions of the modern treasury department of the bank. We are introduced to asset and liability management and funding gaps and liquidity analysis. Trading, risk management and adherence to regulatory requirements is also covered. The reader will end up being quite well informed about the business of banking. 2. Kindleberger, C. A Financial History of Western Europe. OUP, 1994. It is said that you can never fully understand a subject without delving into its history. Professor Kindleberger is a well known and internationally respected authority on this subject, and it is amazing how easily and lucidly he explains even the most difficult topics. Starting with the history of banking and finance, the author outlines the role of money in wars, recessions, panics and booms. He also traces the evolution of money and banking from the days of the goldsmiths to modern banking institutions like the ECB and the IMF. A comparative history of banking in England, Spain, Germany and other nations is also presented, ending with Europe’s position in the world and hopes for the future. 3. Vishwanath, R. & Krishnamurti, C. Investment Management: A Modern Guide to Security Analysis & Stock Selection. Springer, 2009. Formulating a good investment strategy is never easy- it can take years of experimentation and tinkering to get it correct. The best investors have combined theory and practice, analysis and conjecture to see what worked and why. Any modern investor could not hope to win in today’s market without knowledge of the latest instruments and theories and this book is an invaluable guide to the would-be investor. Everything from company and stock valuation to the different investing strategies has been covered in detail. The authors are well researched and have mixed theory with practical analysis including mathematical models for the really serious investor. I have found these three book resources quite important in giving me an idea on how to write about the topic. Short Answer Questions Question 1: Outline the benefits for an IFA firm of ensuring that its training and competence procedures provide due adherence to the FSA’s draft code of ethics, rather than simply complying with FSA rules. (5 marks) The FSA or Financial Standards Authority in the UK has been established with the purpose of protecting the consumer interests by insisting on professional standards of advice and conduct in relation to the provision of financial information that may be used to make investment decisions. By doing so, consumer confidence and trust will be built up in institutions that profess to follow the FSA guidelines as well as adhere to its draft code of ethics. Complying with FSA rules is only a starting point for an IFA firm in the financial services industry. Complying with the FSA’s draft code of ethics in draft and final form however further signifies the institution’s intentions to maintain the highest standards of professional integrity in all matters. The benefits are clear. It is most likely that customers will see this as a positive move and prefer this IFA firm compared to one that only desires to maintain the bare minimum of the FSA regulations as required by law anyway. The FSA has proposed to set up a Professional Standards Board to monitor standards, qualifications and ethical behavior (FSA Retail Distribution Review). Question 2: Explain the options that are available to a widow in relation to her late husband’s capped drawdown (pension) account at the time of his death. Assume that the husband was aged 70 on death, that the widow is also aged 70, and that the fund value is ?200,000. (5 marks) Sorry, I have no idea about this one. Perhaps you can contact a fellow student to get the answer. Question 3: State the benefits and drawbacks of a parent investing a monthly amount into a savings plan for their child, offered by a friendly society. (10 marks) One of the best things that parents can do for their child is provide him or her with a measure of financial security, commensurate to their earnings, savings or station in life. A friendly society is usually one of the first institutions considered because it was the first that came up with an offer for a savings and investment plan. Benefits: 1. You become used to setting aside the amount on a regular basis. 2. The amount usually attracts interest at the going rate and this interest is compounded. The first principal installment will earn interest for 12 months, the second for 11 months etc. This is similar to an annuity. 3. There is a certain amount of satisfaction that a parent gets on knowing that he or she will have accumulated a certain sum for a college education, marriage or other expenses of their child. Risks: 1. This saving is unfortunately not protected against inflation and may fetch you less in terms of purchasing power in the future. 2. Take care to see that the money not locked in for a fixed term. You may want to use it in case of financial or medical emergencies. Read More