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”.
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.
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.
Security issued by a corporation (as opposed to a government) promising to pay interest to the holder of the bond until it is redeemed at maturity when the principal amount is repaid. Also referred to as credit.
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.
The interest paid by the government or company that has raised a loan by selling bonds.
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.
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.
Non-government bonds, including corporate bonds.
Rating given by a credit rating agency to a company or institution indicating the likelihood of default on its bonds or other debt. The highest (most favourable) rating is AAA (triple A).
The risk of a company defaulting on its debt by missing capital (principal) or interest (coupon) payments.
Difference in the yield available on a corporate bond compared to a Government bond of similar maturity. Credit spreads will generally be higher for companies with lower credit ratings to compensate investors for the additional risk undertaken.