Constant proportion debt obligations (CPDOS) are complex debt securities that roll exposure to underlying credit indices they track, such as iTraxx or CDX.

Constant Proportion Debt Obligations: A Post-Mortem Analysis of Rating Models

Constant proportion debt obligations (CPDO) are incredibly complex debt securities that promise investors the high yields of junk bonds with the low-default risk of investment-grade bonds. But the strategy leaves constant proportion debt obligations highly exposed to spread volatility and at the risk of catastrophic loss.
Constant proportion debt obligations (CPDOs) promise investors the high yields of junk bonds with the low-default risk of investment-grade bonds. Fundamentally, CPDOs represent the arbitrage of bond indices, and the strategy can lead to catastrophic loss.
CPDOs started defaulting in the early part of the Great Recession, and rating agencies, such as S&P and Moody's, came under scrutiny for rating CPDOs highly. Constant proportion debt obligations (CPDO) are incredibly complex debt securities that promise investors the high yields of junk bonds with the low-default risk of investment-grade bonds. CPDOs are similar to synthetic collateralized debt obligations as they are a “basket” containing not actual bonds, but credit default swaps against bonds.

Constant Proportion Debt Obligation (CPDO)

A convertible hedge is a strategy where an investor buys a convertible bond and then shorts the stock to increase the overall yield.

A convertible hedge is a trading strategy that consists of taking a long position in a company's convertible bond (or debenture), and a simultaneous short position in the amount of the conversion ratio in the underlying common shares. This can increase the return of the overall strategy, as then the investor is getting interest on the bond plus interest on the increased cash balance from the short sale of stock (less any fees and interest payments on margin balances). A convertible hedge is a trading strategy that consists of taking a long position in a company's convertible bond (or debenture), and a simultaneous short position in the amount of the conversion ratio in the underlying common shares. If the stock rises, the bond gains, the short stock position loses, but the investor still receives the bond interest. If the stock falls, the short position gains while the bond will likely fall, but the investor still receives interest from the bond.

Convertible Hedge

A credit-linked note is a security with an embedded credit default swap that allows the issuer to transfer specific credit risks to credit investors.

A credit-linked note (CLN) is a security with an embedded credit default swap permitting the issuer to shift specific credit risk to credit investors. A credit-linked note (CLN) is a security with an embedded credit default swap permitting the issuer to shift specific credit risk to credit investors. A credit-linked note (CLN) is a financial instrument that allows the issuer to transfer specific credit risks to credit investors. In return for accepting exposure to specified credit risks, investors who buy credit-linked notes typically earn a higher rate of return compared to other bonds. Investors who buy credit-linked notes generally earn a higher yield on the note in return for accepting exposure to specified credit risks.

Credit-Linked Note (CLN)

A death put is an option added to a bond that guarantees that the heirs of the deceased can sell it back to the issuer at par value.

A death put is an option added to a bond that guarantees that the heirs of a deceased bondholder can sell it back to the issuer at par value. Usually, it is protection from events that can have an adverse effect on the bond's value, like interest rate risk, but in this case, it is protection from interest rate risk if a very specific event—the bondholder's death—occurs. As with any option, the death put gives the bondholder's estate the right, but not the obligation, to sell the bond back to the original issuer at face value in the event of the bondholder's death or legal incapacitation. Normally, a bond's coupon rate is predicated on the prevailing interest rates, so any changes in the market rates will have an effect on the value of the bond. A death put, or survivor's option, allows a bondholder's beneficiaries to sell back the bond to the issuer at par value if the bondholder dies before maturity.

Death Put

An equity linked note (ELN) is an investment product that combines a fixed income investment with additional returns tied to the performance of equities.

An equity-linked note (ELN) is an investment product that combines a fixed-income investment with additional potential returns that are tied to the performance of equities. In the case of a note linked to an equity index, the security would typically be called an equity index-linked note. In the simplest form, a $1,000 5-year equity-linked note could be structured to use $800 of the fund to buy a 5-year strip bond with a 4.5% yield-to-maturity and then invest and reinvest the other $200 in call options for the S&P 500 over the 5-year life of the note. In practice, an equity-linked note will have a participation rate, which is the percentage amount that the investor in the note participates in the appreciation of the underlying equity. There are also types of equity-linked notes that use dynamic hedging instead of options, deploying leverage to increase returns from the underlying equity.

Equity-Linked Note (ELN)

An interpolated yield curve or "I curve" refers to a yield curve created using data on the yield and maturities of on-the-run Treasuries.

An interpolated yield curve (I curve) is a yield curve derived by using on-the-run Treasuries. When the yield curve is plotted using data on the yield and maturities of on-the-run Treasuries, it is referred to as an interpolated yield curve or I curve. An interpolated yield curve (I curve) is a yield curve derived by using on-the-run Treasuries. The yield curve is the curve that is formed on a graph when the yield and various maturities of Treasury securities are plotted. Once the interpolated yield curve has been derived, yield spreads can be calculated from it as few of the bonds have maturities comparable to those of the on-the-run Treasuries.

Interpolated Yield Curve (I Curve)

Master notes are short-term debt instruments issued by the Federal Farm Credit Banks Funding Corporation.

Federal Farm Credit Banks Consolidated Systemwide Master Notes

Master notes are short-term debt instruments issued by the Federal Farm Credit Banks Funding Corporation. The corporation distributes Farm Credit Debt Securities, such as discount notes, designated bonds, floating-rate bonds, fixed-rate bonds and retail bonds to various investors, including commercial banks, states, municipalities, pension and money-market funds, insurance companies, investment advisers, corporations, foreign banks and governments, and other investors in the United States and internationally. According to the Federal Farm Credit Banks Funding Corporation, investors should have sufficient knowledge and experience in financial and business matters to evaluate the notes, as well as the merits and risks of investing in them. Master notes are short-term debt instruments issued by the Federal Farm Credit Banks Funding Corporation. Master notes are a short-term debt instrument issued by the Federal Farm Credit Banks Funding Corporation.

Master Notes

Matrix trading is a fixed-income strategy that seeks to capitalize on the discrepancies in the yield curve by instituting a bond swap.

Matrix trading is a fixed income trading strategy that looks for discrepancies in the yield curve, which an investor can capitalize upon by instituting a bond swap. A matrix trader would buy the AAA-rated bond and sell the AA-rated bond, expecting the yield spread to widen (causing the price of the AA bond to fall as its yield rises). Matrix trading is a strategy of swapping bonds in order to take advantage of temporary differences in the yield spread between bonds with different ratings or different classes. Matrix trading is a fixed income trading strategy that looks for discrepancies in the yield curve, which an investor can capitalize upon by instituting a bond swap. Assume that the difference in interest rates between U.S. short-term Treasuries and AAA-rated corporate bonds has historically been 2%, while the difference between Treasuries and AA-rated bonds is usually 2.5%.

Matrix Trading

A modified pass-through certificate is a fixed-income security that provides investors with income generated from a pool of underlying assets.

Mortgage-Backed Securities and Collateralized Mortgage Obligations

A modified pass-through certificate is a type of fixed-income security that provides investors with income generated from a pool of underlying assets or loans. By receiving a government-backed guarantee of future interest and principal payments, investors in modified pass-through certificates can essentially eliminate the default risk associated with mortgage-backed securities. However, investors in modified pass-through certificates are not protected against prepayment risk, since any early payments of principal would be passed along to the certificates’ investors. The agencies that hold the loans guarantee interest payments to investors and make those payments regularly, whether the agency receives interest payments via the underlying note or not. Investors who wish to further reduce their risks can invest in fully modified pass-through certificates, which mitigate prepayment risk by fully guaranteeing both the amount and timing of interest and principal payments.

Modified Pass-Through Certificate

Prepayment risk is the risk associated with the early unscheduled return of principal on a fixed-income security.

Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. For a callable bond, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk. Consequently, prepayment risk, which describes the chance of the issuer returning principal early and the investor missing out on subsequent interest, is only associated with callable bonds. The prepayment risk is highest for fixed-income securities, such as callable bonds and mortgage-backed securities (MBS). Investors should consider prepayment risk, as well as default risk, before choosing corporate bonds over government bonds.

What Is Prepayment Risk?

Repudiation is disputing a contract and refusing to honor it. Repudiation is most relevant to fixed income securities, particularly sovereign debt.

Repudiation involves disputing the validity of a contract and refusing to honor its terms. If one party believes another party has repudiated the contract, the innocent party may:
Continue on with the contract
Accept the repudiation and elect to terminate the contract
Repudiation itself does not terminate a contract. If you wrongfully form the view that the other party has repudiated the contract and terminate the contract based on this, and you are not entitled to do so, you could be held to have actually repudiated the contract yourself! The party on the receiving end of repudiation (i.e., the party not pulling out of the contract), should be careful and ensure they respond appropriately. Put simply, determining repudiation requires a detailed review of the actual terms of the contract and the obligations of each party, and then the conduct and statements of the parties.

Repudiation

Treasury lock is a hedging tool used to manage interest-rate risk by effectively securing the current day's interest rates on government securities.

A Treasury lock is a hedging tool used to manage interest-rate risk by effectively securing the current day's interest rates on federal government securities, to cover future expenses that will be financed by borrowing. When a certain yield is important to an investor’s or company’s investment strategy, but there is uncertainty in the economy about the future direction of Treasury yields, a company or investor may choose to buy a Treasury lock. A Treasury lock is a hedging tool used to manage interest-rate risk by effectively securing the current day's interest rates on federal government securities, to cover future expenses that will be financed by borrowing. Treasury locks provide the user the benefit of locking in benchmark rates associated with future debt financing and are commonly used by companies that plan to issue debt in the future, but want the security of knowing what interest rate they will pay on that debt. A Treasury lock is an agreement between the company issuing a security and the investor in the security that holds or locks the price or yield of the security.

Advanced Fixed Income Trading Concepts

More in Trading

Terms in Advanced Fixed Income Trading Concepts