Glossary

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.

Bond

A loan, usually taken out by a government or company, which normally pays a fixed rate of interest over a given time period, at the end of which the loan is repaid.

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”.

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.

Corporate bond

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 paid. Also referred to as credit.

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.

Coupon

The interest paid by the government or company that has raised a loan by selling bonds.

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.

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

Non-government bonds, including corporate bonds,

Credit rating

Rating given by a credit 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).

Credit risk

The risk of a company defaulting on its debt by missing capital (principal) or interest (coupon) payments.

Credit spread

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.

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.

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.

Diversification

Risk reduction achieved by spreading investment across a range of assets or a range of securities in the same asset class.

Duration

A measure of the sensitivity of a bond or bond fund to changes in interest rates. The longer a bond or bond fund’s duration, the more sensitive it is to interest rate movements.

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.

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.

Floating rate notes (FRNs)

A bond or loan instrument whose interest varies in line with short-term interest rates.

Gilt-edged

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

High yield bonds

Bonds with a low credit rating from a recognised credit rating agency. They are considered to be at higher risk of default than better quality, ie, higher-rated bonds, but have the potential for higher rewards.

Index-linked bonds

Bonds where both the value of the loan and the interest payments are adjusted in line with inflation until they mature. Also referred to as inflation-linked bonds.

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.

Inflation-linked bonds

Bonds where both the value of the loan and the interest payments are adjusted in line with inflation until they mature. Also referred to as index-linked bonds.

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.

Investment grade bond

Corporate bond that has been given a relatively high rating by the credit agencies. Offers higher expected returns than government bonds/gilts as a reward for taking on additional risk. Also known as credit, the ratings rank from AAA (highest) to BBB (lowest).

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.

Leverage

Use of borrowed money to increase returns.

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 loan

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

Liabilities

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

Liquidity

The ability to convert an asset to cash quickly. The degree to which this can be done without affecting the price of that security should also be taken into account.

London Interbank Offer Rate (LIBOR)

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.

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.

Maturity

Length of time until the last interest payment and the principal of a bond are redeemed.

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.

Net asset value (NAV)

The current value of an entity's assets minus its liabilities.

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.

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.

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.

Price-earnings ratio

A measure that compares a company's current share price to its earnings per share. It provides a guide to the market's opinion about the company's future earnings prospects. Calculated by dividing the market value per share by the earnings per share.

Principal

The face value of a bond, which is the amount due back to the investor by the issuer when the bond reaches maturity.

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”.

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.

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.

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.

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

This refers to either the interest received from a bond or to the dividends received from a share. It is usually expressed as a percentage based on the investment's costs, its current market value or its face value.

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”.