The Hidden Meaning of Derivatives and Defaults
Mark Gilbert
2006-03-08 19:07 (New York)
By Mark Gilbert
March 9 (Bloomberg) -- Last month, my fellow columnist John
Dorfman published a tongue-halfway-in-cheek dictionary ofs tock
market terms. In a similar vein, here’s a suggested lexicon for the
bond market.
Alpha: The amount of excess return promised by a hedge fund
manager to justify his pocketing 2 percent of your capital and 20
percent of any profit. It seems there are only two ways to generate
alpha. The first is to sell General Motors Corp. bonds and
simultaneously buy those of its finance unit, GMAC. The second is
to go long GMAC debt while being short GM securities. Anyone who
can’t see the difference between these two trades clearly isn’t as
bright as the hedge fund guys. They are displaying their
individuality by making identical bets on GMAC regaining its
investment-grade rating while GM slides further toward filing for
bankruptcy protection.
Bond documentation: The legal papers accompanying the
securities you bought a few months back. Remember? Small typeface,
hundreds of pages, even duller than that Annie Proulx book you
failed to finish on vacation? You filed them in the round basket on
the floor next to your chair. Now, there are whispers that a gang
of buyout firms may purchase the bond issuer and load it with debt,
so you really, really need to read that small print. It’s dumpster-
diving time.
Broker: Anyone who drinks more than you do.
Cheap: Any bond yielding more than 4 percent.
Credit analyst: Someone who spent 2004 telling you why General
Motors would hang on to its investment-grade rating, and will spend
2006 telling you why bankruptcy is inevitable.
Credit-default swap: (A) A way to insure your bond investments
against non-payment by the borrower. (B) As ecurity that lets
traders bet against a company’s creditworthiness, in sizes several
times bigger than the company’s outstanding debt, without filling
in any pesky paperwork to settle the trades. (C) A derivative that
allows fund managers to dodge the restrictions placed on their
investment strategies by their trusty trustees.
Default: In the dim and distant past, issuers other than
automakers would occasionally be unable to make theiri nterest
payments. Airlines, or telecommunications companies, for example.
Even governments. Post-traumatic amnesia has allowed many investors
to erase these painful memories, and default now applies solely to
the auto industry, and is of no concern anywhere else. Russian
bonds, Argentina’s bills? Ship ’em in.
Derivatives: (A) Innovative financial instruments that allow
different types of risk to be sliced, diced and transferred
efficiently around the global capital markets, according to market
regulators. (B) ``Weapons of financial mass destruction’’ that,
when you try to unravel them, become the equivalent of trying to
carry ``a cat home by its tail,’’ according to Warren Buffett.
Hedge fund manager: The guy wearing an open-necked shirt under
an Italian suit who drives that Bentley sports car you’ve been
lusting after. His unique investment strategy, developed using his
years of experience in the capital markets and honed by proprietary
mathematical models running on expensive supercomputers, uses a
short/long position to . . . (see Alpha entry).
High-yield: Any bond offering more than 5 percent.
Hybrid bonds: Debt securities that allow fixed-income money
managers to earn a smidgen of additional yield by taking on equity-
type risks with no prospect of equity-sized returns.
Inflation: In the dim and distant past, the purchasing power
of the fixed-interest payments available on bonds was eroded by
rising consumer prices. Thanks to advances in central banking
technology, inflation has been vanquished. Investors can happily
accept the skimpy yields currently on offer in the bond market
without fear of faster inflation making them look like bandwagon-
hopping dummies.
Journalist:S omeone who has never traded a security, can
barely do long division, isn’t licensed by anyone, was rejected by
every investment bank graduate trainee program, yet still bitches
about how much money you guys get paid.
Leverage: In previous dictionaries, this was a Bad Thing,
since it applied to a company that had lots of debt, thus
undermining the value of the debt owned by you. Under current
definitions, it is a Good Thing, since it keeps those private
equity buyers and their debt-financed takeovers at bay.
Pension fund manager: Anyone who thinks it makes sense to lend
to the U.K. for 50 years at 3.75 percent, to the U.S. for 30 years
at 4.7 percent, or to Poland for 50 years at 4.5 percent; theb uyer
of last resort for overpriced bonds.
Rating companies: Self-appointed alphabet-soup chefs.
Companies pay them to ladle out credit ratings, which give
investors a snapshot of a borrower’s financial health at a
particular moment in time, usually six to nine months ago.
Spread: The number of additional basisp oints of yield you
used to be able to squirrel away by shunning government debt and
instead piling into corporate bonds or emerging market bonds.N ow
archaic.
Vulture Fund: Someone who paid less than you, a lot less, to
buy the bonds of the auto-parts maker thatf iled for Chapter 11
bankruptcy protection a few weeks after you invested in its debt.
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