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”.
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 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.
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.
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.
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.
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).