Glossary

Asset-backed commercial paper (ABCP)

Asset-backed commercial paper (ABCP) is a type of commercial paper that is collateralised by other financial assets. Usually issued by a bank or other financial institution, ABCPs are typically short-term investments that mature between 90 and 180 days and are specifically designed to meet short-term financing needs.

Asset-backed securities (ABS)

Securities backed by receivables other than those arising out of real estate. Some examples are autos, credit cards and royalties. It is common in securitisation markets to distinguish between ABS and mortgage-backed securities. However, in markets outside the United States, the word ABS might cover all classes of securitised instruments, including those out of mortgages.

Backwardation

In the futures market backwardation is a situation in which the price for future delivery of an item is lower than the amount of money required for immediate delivery (the spot price).

Basel II

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Introduced in June 2004, Basel II was published to create an international standard for banking procedures and requirements to ensure a prosperous banking system. As a general rule at the core of these guidelines is that the greater the risk to which a bank is exposed, the more capital they need to secure its stability.

Basis trading

Basis trading is an arbitrage strategy based on purchase of a particular security and the sale of a similar security. This kind of strategy is usually used when an investor suspects that the two securities in question have been mispriced relative to each other, and that this imbalance will correct itself, with the gain on one side of the trade more than cancelling out the loss on the other side.

Basis-point value

Basis-point value describes the change in value of an asset or portfolio per 0.01% change in yield. Basis points (called bps) are used to compare the change in bond yields. For example, if a bond’s yield rises by 3%, then the yield moves by 300bps.

Benchmark

Measure against which a portfolio's performance is assessed. For total assets, the benchmark may be customised or be a peer group average or median.

Bullet bond

Sometimes known as a virgin bond, a bullet bond cannot be redeemed until maturity; in other words, it is not callable. The coupon is normally fixed and is guaranteed until the bond matures if there is no default, and the principle is then repaid to the investor. Bullet bonds usually have lower interest payments than callable bonds because the issuer cannot redeem the bond early when market interest rates may favour them (ie the issuer), giving investors them some in-built protection.

Call

A call is an option contract that provides an investor with the right (not the obligation) to buy a specified amount of a security at a set price by a specific date. A call option will become more attractive as the price of an asset appreciates, once the actual price exceeds the call price (also known as the strike price) then the option would be referred to as “in the money”. If the actual price is below the strike price then the call option is said to be “out of the money”, and if equal “at the money”.

Callable bond

A callable or redeemable bond can be redeemed by the issuer before its maturity date. In effect, the issuer effectively has a call option from the investor to buy back the bonds at a specified price known as the ‘call price’, which is normally higher than the issue price of the bond. If interest rates fall, the issuer can use the callable bond to call their bonds and refinance debt at the new lower rates.

Capital structure arbitrage

Capital structure arbitrage is a hedge fund strategy which involves making a profit from the miss valuation of a company’s debt and equity. As bondholders are rated higher than shareholders in the capital structure of a company in terms of recovery there may be an associated mispricing between bonds and stock. If bad news is released to the market on the credit of a company, the equities could receive a disproportionate change in price relative to the bonds because of the differences in risk. With capital structure arbitrage an investor will buy the shares and short the bonds to profit from the miss valuation.

Catastrophe bonds (CAT bonds)

Catastrophe bonds (CAT bonds) are debt instruments that are typically used by insurance or reinsurance companies to pass on risk to investors in the event of a catastrophe.

CAT bonds feature a built-in clause that allows the issuer to either defer or eliminate their obligation to pay interest and/or the principle. For this reason, they are considered high-risk investments and usually come with high yields as a result. CAT bonds are often used to diversity risk in a portfolio because they are typically unconnected to stock markets or economic circumstances.

Cheapest to deliver (CTD)

When a derivative contract is physically settled and has multiple deliverables (stock, bonds, commodities etc), the CTD is the lowest-cost product that can be used to cover the contract. The CTD therefore affects the pricing of physically settled derivative contracts.

Collateralised debt obligations (CDOs)

Collateralised debt obligations (CDOs) are investment vehicles designed to raise money by issuing securities using the proceeds to invest in a pool of assets including bonds, leveraged loans, asset-backed securities and private placements. A CDO’s cashflows are split into tranches with different risk/return profiles and distributed to investors. The credit rating of each one indicates the quality and diversity of the underlying assets and its level of protection from lower-ranked tranches.

If there are any defaults in the portfolio of assets, the lowest-ranking tranches will be hit first. As a result, the principle and coupon generated by the portfolio assets is applied to the tranches in descending order of seniority, with equity the lowest in the pecking order, and senior debt the highest.

Commercial mortgage-backed security (CMBS)

A mortgage-backed security secured by a loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders.

Commercial paper (CP)

Commercial paper is a short term debt instrument issued by a company to finance short term commitments. The issuer is only obliged to pay the face value on the maturity date (no coupon) so they are issued at a discount to offer an attractive yield to an investor. They are usually unsecured so only firms with a high quality debt ratings will easily find buyers without offering a significant discount. They are typically no longer than 270 days in maturity.

Constant proportion debt obligation (CPDO)

A constant proportion debt obligation (CPDO) is a synthetic collateralised debt instrument backed by a debt security index like iTraxx, designed to give long-term exposure to credit risk on a highly rated note. The investment index that backs the CPDO is periodically rolled over, with the special purpose vehicle (SPV) creating a spread by buying protection on the old index and selling protection on the new index. By continually buying and selling derivatives on the underlying index, the CPDO can customise the amount of leverage it employs to try and make additional returns off of the index price spreads at any point in time.

Correlation

Correlation measures how the prices of two securities move in relation to each other. Two negatively correlated securities move in opposite directions, while two positively correlated ones move in the same direction. In the unlikely event of perfect correlation, they will move to exactly the same extent, ranging from -1 (perfect negative correlation) to +1 (perfect positive correlation), with 0 indicating no correlation between the two.

Covenant

A covenant is a contractual provision written into a bond for the bondholder’s protection, a covenant is a legally binding contractual provision that obliges the issuer to undertake certain actions (positive covenant) or avoid certain actions (negative covenant). As an example, a positive covenant could force the issuer to maintain a certain debt/capital ratio to avoid any negative impact from a leveraged buyout on bondholders.

Covenant light (cov-lite)

Covenant light (cov-lite) describes debt contracts that come without the typical covenants designed to protect the investor. Unlike bonds with traditional covenants, cov-lite bonds are seen as riskier because they lack the same built-in early warning mechanism. In the past, banks would insist on covenants to protect themselves, but leveraged buyouts (LBOs) and competition has seen debt terms become less stringent.

Covered bond

A covered bond is a bond that is secured by cash flows from a pool of mortgages or public sector loans. Although they vary in structure the common feature of a covered bond is that investors have a preferential claim in event of default. If the issuer becomes insolvent, the pool of assets covers the liability of the bond. They will therefore typically be assigned an AAA credit rating. They are similar to asset backed securities (ABS) but they differ in that they remain on the issuers consolidated balance sheet.

Credit default swaps (CDS)

Are a type of derivative, namely financial instruments whose value, and price, are dependent on one or more underlying assets. CDS are insurance-like contracts that allow investors to transfer the risk of a fixed income security defaulting to another investor.

Credit default swaps (CDS)

Credit default swaps (CDS) are swap contracts which enable two parties to transfer fixed income credit risk between themselves. The buyer of a CDS pays periodic payments premiums to the seller in return for a guarantee of a compensation pay-off in the event of default on an underlying investment (normally a bond or loan). The seller of a CDS guarantees the creditworthiness of the underlying investment and receives payments for taking on the risk. However, the buyer of a CDS contract does not need to own the underlying investment.

Credit risk

The credit risk of a bond is tied to the relative risk of default of the lender on a coupon or return of principal. This means that the lender’s credit strength has a significant effect on the yield paid on bonds that it issues. Because investors typically expect a higher return for taking on more credit risk, the more risky the company, the higher the yield offered.

Credit spread

The credit spread marks the difference in yield between bonds of different credit quality. The size of the spread shows the extra yield available to an investor from buying a higher-risk bond compared to a ‘safer’ one. Credit spreads are usually quoted in percentage points (also known as basis points or bps) in relation to a risk-free (or low-risk) benchmark investment or rate (eg gilts or LIBOR).

Debt-equity ratio

Calculated by dividing a company’s total liabilities by stockholders' equity, the debt–equity ratio shows how much debt and equity the company is using to finance its assets. For example, a high debt–equity ratio usually shows that a company has taken an aggressive approach to financing its growth with debt.

Deflation

Deflation is a negative inflation rate. It occurs through the sustained decrease in the average price of goods and services in the economy until the annual inflation rate falls below zero increasing the real value of money. It is often caused by a reduction in the supply of money or credit into the economy and leads to increased unemployment due to lower levels of demand which can in turn lead to economic depression.

Dirty price

The dirty price of a bond factors in the present value of all future cashflows and accrued interest on the next coupon payment. When a bond is between coupon payment dates, accrued interest starts to build up. As the next coupon payment date approaches, accrued interest grows until the coupon is paid. Once the coupon is paid, the clean price and dirty price are exactly the same, with the clean price calculated by subtracting the accrued interest from the dirty price.

Discount margin

The discount margin is the return earned on top of the underlying index for floating rate security, with the size of the margin dictated by the price of the security. If the price of a floating rate note is equal to par, the investor’s discount margin is equal to the reset margin – the fixed spread above the index).

Duration

Duration measures the amount of time it takes for a bond’s price to be repaid by its internal cashflows. Investors pay attention to duration because bonds with higher durations carry higher risk and have higher price volatility than bonds with lower durations.

Earnings before interest, tax, depreciation and amortisation (EBITDA)

EBITDA is a commonly used indicator of financial performance that can be used to compare profitability between companies and industries. Simplified it is a company’s operating revenue minus their operating expenses and is often used for stock analysis.

Effective yield

If a coupon is reinvested after being received, the return that could be expected is the effective yield. For plain vanilla bonds, the effective yield in a period of rising interest rates is usually higher than the quoted yield to compensate for the effect of compounding coupon payments.

EURIBOR (Euro Interbank Offered Rate)

EURIBOR is the reference rate at which banking institutions borrow money from other banks on the Euro wholesale money market (interbank market). It is an average of inter-bank deposit rates offered by representative banks ranging from one week to one year to maturity.

Exchange-traded fund (ETF)

Seen by many investors as a more dynamic alternative to mutual tracker funds, an ETF is an investment vehicle that tracks an index or a basket of securities, but trades like a stock throughout the day. ETFs usually trade at very close to the net asset value (NAV) of the underlying assets.

First-to-default basket (FTD)

A first-to-default basket (FTD) is a selection of companies on which an investor buys or sells protection. A credit default swap contract is then set up based on more than one company. After the first default, a predetermined credit event will trigger a pay out, signalling the end of the FTD contract. The premium depends the correlation of the companies, with a higher correlation meaning a lower premium as the companies have similar credit risk profiles, and vice versa.

Flattening trade

A flattening trade is the decrease in the spread between long- and short-term bond yields. In this scenario, long-term bond prices will increase relative to short-term prices, causing the yield curve to flatten.

Gilt-edged

A bond issued by the UK government. Given the nature of the issuer there is a very low probability of default.

Gross distribution yield

The gross distribution yield is the annual historical cashflow relative to the principal amount of a bond. This figure mostly represents the expected cashflow generated by interest over a year, but can also include return of principle distributions or capital gains.

Gross redemption yield

Also called the redemption yield of yield to maturity (YTM), the gross redemption yield is the total return on a security including capital growth and expected income if held to maturity.

Inflation swap

An inflation swap is a type of swap where two counterparties agree on a long term contract based on opposite cash flows. One counterparty's cash flows are linked to a price index (usually the Consumer Price Index (CPI)) and the other counterparty is linked to a conventional fixed cash flow. If the variable rate (CPI) is higher than the fixed rate then the linked counterparty makes a profit and the fixed counterparty makes a loss.

Infrastructure finance

Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure where project debt and equity are used to finance the project, and debt is repaid using the cashflow generated by operation of the project, rather than the general assets or creditworthiness of the project sponsors.

The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Institutional funds

Assets managed by investment banks, life assurance companies and fund management companies on a collective basis for corporate clients rather than private individuals. Includes pension schemes, insurance funds, unit trusts and investment trusts.

Interest rate

Rate of interest. Usually linked to movements in the Bank of England base rate in the UK.

iTraxx

iTraxx is the brand for a group of international credit default swap indices that covers the credit derivative markets of Europe Asia and Australia. They provide investors the ability to trade the risk/return characteristics of underlying assets between one another without actually transferring the physical assets.

An investor can choose to go long or short on the index which is the equivalent of selling credit default swap protection or buying protection respectively. The constituents of the indices are updated every six months depending mainly on their liquidity position, a process known as "rolling" the index.

Leveraged buyout (LBO)

A leveraged buy out is the acquisition of another company funded primarily through borrowed money (typically loans or bonds). In a usual LBO, a takeover may be made with 90% debt to facilitate a large acquisition without the need for capital up front.

It is common that the assets of both the acquirer and the company being acquired are used as collateral for the loan. If such a transaction is too highly leveraged and the acquirer cannot keep up with the interest payments, then it can lead to the bankruptcy of the acquired company. As a result the bonds or loans used for LBOs are not considered investment grade due to the risks involved and would typically be considered junk bonds.

Leveraged loans

Debt issued by companies, typically to finance internal growth, acquisitions, mergers and leveraged buy-outs (LBOs) by private equity sponsors.

LEVX

Built from credit default swaps, LEVX is an iTraxx index for European corporates with leveraged loan exposure. It is split into separate senior debt and subordinated debt indexes. Generally used by large commercial banks to speculate or hedge on assets, the LEVX usually falls in line with falling credit quality, and vice versa.

Liabilities

Payments due to be made (eg future pension payments).

LIBOR (London Interbank Offer Rate)

A daily published rate reflecting the average rate at which a number of banks in the London market offer to lend on the interbank market.

Loan credit default swaps (LCDS)

In a loan credit default swap (LCDS), the credit risk of underlying loans is swapped between two parties. Basically the same in structure as a ‘vanilla’ credit default swap (CDS), the underlying debt of LCDS is limited to syndicated secured loans and not bonds. Also, LCDS are based on secured loans so they normally have higher recovery rates in the event of default and therefore trade at tighter spreads.

Management buyout (MBO)

In a management buyout (MBO), a company’s current managers buy a large chunk - or all - of its equity. An MBO is very similar to other company acquisitions, except that its own managers are the buyers, which cuts down due-diligence process or warranties. If the company is public, the management will convert it to a private company, although most MBO targets are already private.

Mezzanine debt

Refers to a middle layer of debt in leveraged buyouts. Mezzanine debt is ranked below the senior debt layer and above the equity layer. A typical mezzanine investment includes a loan to the borrower, in addition to the borrowers issuance of equity in the form of warrants, common stock, preferred stock, or some other equity investment. Mezzanine finance shares characteristics of both debt and equity financing.

Monoline

Monoline refers to a business that operates in one specific financial area. The aim of such companies is to provide specialist expertise in one area to allow more efficient and effective trading. The most notable example is that of monoline insurers who through their specialisation ensure timely repayment when an issuer defaults on a bond.

Mortgage-backed security (MBS)

A mortgage backed security is a type of asset backed security which is backed by the cash flows from a pool of mortgage loans. The mortgages must have originated from a regulated and authorised financial institution. In the US mortgage market because owners have the option to pay more than the required monthly payment (up to the whole loan), the cash flows from an MBS are not always known in advance, which can prove a disadvantage to investors.

Non-investment grade

A rating attributed to a security that is deemed speculative, i.e. less certain in respect of the preservation of capital, in the opinion of a credit rating agency such as Fitch Ratings, Moody’s or Standard & Poor’s.

Option-adjusted spread (OAS)

For a bond with embedded options, the option-adjusted spread (OAS) shows the spread over the benchmark minus the cost of the options. In general, a higher OAS indicates a higher return, for higher risk.

Par value

The face value of a bond and the amount that will be paid back to the investor on maturity. Prices of bonds rise and fall in line with supply/demand factors and should not be confused.

Passive management

Investment approach which aims to match the returns on a particular market index.

Plain vanilla bond

As the most basic type of investment instrument, a plain vanilla bond has a fixed maturity at which it returns par value to the investor and a fixed amount of interest which is paid each year by the issuer.

Preference share

A preference share is a class of equity in a company that offers preferences over common stock. This includes priority for dividend payments and a higher claim on assets and earnings in the event of liquidation. Preference shareholders are also entitled to a fixed dividend whereas ordinary shareholders are not. They can therefore be seen as having both debt (fixed interest) and equity (ownership and growth potential) characteristics. Preference shareholders do not normally have any voting rights in a company.

Put

A put is an option contract that provides an investor with the right (not the obligation) to sell a specified amount of a security at a set price by a specific date. A put option will become more attractive as the price of an asset depreciates, once the actual price is lower than the put price (also known as the strike price) then the option would be referred to as 'in the money'. If the actual price is above the strike price then the put option is said to be 'out of the money', and if equal 'at the money'. A put option is the opposite of a call option.

Quantitative easing

Quantitative Easing is a tool of monetary policy through which the money supply in the economy is increased. It is often described as the government printing more money to stimulate the economy by easing pressure on banks and enhancing their liquidity. This strategy was most notably employed by the Bank of Japan (BOJ) in 2001 as an attempt to fight deflation.

Real rates

The real interest rate is the adapted rate of return taking into account the effect of inflation over time. When initially investing in a bond the inflation rate for the whole of the term will not be known and therefore an investor faces the risk that volatility in inflation will eat into their return. The real interest rate is calculated by subtracting the inflation rate from the nominal rate of interest to provide an actual rather than nominal rate of interest.

Redemption

The date at which a bond issuer pays back the sum borrowed (principal) to the bond holders.

Refinance

Refinancing is the process of replacing existing debt with new debt under different terms. Companies or individuals will typically refinance to reduce interest cost, extend the term of the loan, reduce risk exposure or raise capital. There is usually an associated penalty or cost for refinancing debt in the above ways.

Repurchase agreement (Repo)

A repurchase agreement or repo is a form of short term debt that usually utilises government securities. The seller sells the security, agreeing to repurchase at a set date in the future, to the buyer who agrees to sell at that set date (typically overnight but it can be for up to a year). The seller makes a charge for the loan known as the repo rate, which is the difference between the buying and selling price. For example if party A sold at £100, in order to make the loan worthwhile he would repurchase from B at say £90, an effective interest rate of 10%. Repo contracts are also available from non government securities and are known as “credit repos”.

Second-lien loan

A second-lien loan is company debt ranking just behind senior debt. A second-lien lender usually agrees to subordinate its claims on the assets to those of the first-lien (more senior) secured lenders.

Senior debt

Senior debt is company debt that has a priority over subordinate debt for repayment purposes in the event of the issuer going bankrupt.

Separately traded and registered interest and principals securities (STRIPS)

Strips are gilts that have been stripped down into two separate cashflows: the coupon and the principal. These cashflows can then be traded separately as zero-coupon and interest-only gilts.

SICAV

An open-ended collective investment scheme common in Western Europe, especially Luxembourg, Switzerland, Italy, Spain, Belgium and France.

SICAV is an acronym for Spanish sociedad de inversión de capital variable, French société d'investissement à capital variable, Italian società d'investimento a capitale variabile.

Step-up coupon

As a clause written into a bond, a step-up coupon means that the bond pays an initial rate of interest followed by a higher coupon. As an example, a 10-year bond might pay a 6% coupon for the first six years and a 7% coupon for the final four years.

Subordinated debt

Subordinated debt, also known as junior debt, refers to company debt that is of a lower rank than its standard debt. In the event of default, subordinate debt has a lower priority for repayment than senior debt. The capital structure of a company will typically be senior debt (highest priority) followed by subordinated debt (lower priority) with equity at the bottom (lowest priority). As a result subordinated debt usually carries with it a higher rate or return than senior debt to compensate investors for the increased risk. Companies such as banks will have a more complex debt structure which has various levels of subordinated debt.

Sub-prime

Sub-prime lending happens when financial institutions lend money to individuals that fall below prime underwriting criteria. These borrowers are seen as riskier for reasons like bankruptcy, loan delinquency or limited debt experience. Sub-prime was first coined as a term during the 2007 credit crunch as a result of huge losses from defaults on sub-prime debt that rocked the US mortgage market.

Supranational

A supranational is an internationally recognised organisation or union that unites together member states from different countries to make collective decisions and vote on issues that affect them all. The EU and World Trade Organisation (WTO) are examples of supranational bodies.

Swap spread

The swap spread shows the difference between the swap interest rate on a contract and the government bond yield for any given maturity. Swap spreads are based on several factors including LIBOR, the credit risk of the swap parties and external economic factors like interest rates. Commonly used to measure risk sentiment in the market as it represents investors’ exposure to future interest rate fluctuations, narrower swap spreads show higher risk appetite while wider spreads show lesser appetite.

Swaps

A swap is a derivative contract where two counterparties agree to exchange separate streams of cashflows, known as ‘legs’. Swaps are based on a notional principle amount which is not usually physically exchanged between counterparties. This means they can be used to create unfunded exposure to an underlying asset by making a profit or loss on price movements. Investors use swaps to either hedge against certain risks (through an inflation swaps) or speculate on changes in the underlying price of an asset (through a total return swap).

Synthetic

A synthetic investment instrument simulates the returns of an actual investment using several features derived from other assets. A simple example would be buying a call option and simultaneously selling a put option on a stock. The potential for gain would be the same as holding the stock itself, but the vehicle is itself synthetic.

Synthetic shorting

Involves using a derivative instrument to take a short position on an asset. 'Traditional' shorting requires an investor to borrow an asset, sell it, hopefully buy it back at a lower price and return the asset to the owner. 'Synthetic' shorting is usually cheaper as it excludes the borrowing fee and the cost of selling and buying the asset.

Total return swap

A total return swap is a swap contract which involves one counterparty making predetermined payments on a fixed or variable basis whilst the other party makes payments base on the total return of an underlying asset (usually a bond or index). If the total return of the underlying asset (also known as the reference asset) is higher than the predetermined payment then the set payment counterparty makes a profit and the owner of the reference asset makes a loss. Total return swaps therefore allow exposure to the return of an asset without actually having physical ownership.

Trade-weighted index (TWI)

A trade-weighted index (TWI) is a weighted average of exchange rates of domestic and foreign currencies. Each country’s weight within the index is equal to its share of total trade. Also known as the effective exchange rate, a TWI measures the average cost of a domestic good relative to those of one of its trading partners and is used to compare exchange rates between economies.

VIX

The VIX or CBOE (Chicago Board Options Exchange) Volatility index is an indicator of expected market volatility in S&P 500 index options. A high VIX value indicates a more volatile market where investors will demand a greater premium for the increased risk. It is often used as a gauge of market fear providing an insight of volatility expectations for the next 30 days.

Yield compression (bonds)

Situations where short-term interest rates are higher than rates on longer-term loans.

Yield curve

A yield curve shows the relationship between the yield and maturity of a bond in graphic form, plotting the yield of bonds of equal credit quality against their relative maturity dates at one point in time. The yield curve plays an important role in reading the current and future state of debt markets and the broader economy, with shifts driven by factors like currency fluctuations, market sentiment, interest rates and supply and demand. Yield curves fall into three main types: normal, inverted and flat.

A normal yield curve is seen when long-dated bonds have higher yields than short-dated bonds to factor in the long-term exposure of invested money. This usually indicates that the economy is expected to grow, accompanied by a rise in inflation. An inverted yield curve happens when long-dated bond yields drop below those of short-dated bonds. This shows the expectation of a declining economy where there is an expectation of decreasing interest rates and investors will settle for lower long term yields. A flat yield curve occurs when bonds of all maturities show similar yields. This can indicate economic uncertainty and is likely to revert to a normal or inverted curve further down the line.

Yield to maturity (YTM)

The yield to maturity is the expected return on a bond if it is held to its maturity date. It is expressed as an annual percentage figure and assumes that all interest payments are reinvested at the same rate as originally invested. It can also be referred to as the “redemption yield” or shortened simply to “yield”.