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Glossary

In Which Some Specialised Terms Used In Posts Within This Blog May Be More Or Less Defined

Bond : In the financial sense a bond is a promise to repay a debt, usually contractual (though as far as the City of London is concerned it is simply a solemn promise with no specific context and which is as good as your word). Bonds generally take the form of a security (which in the past generally meant that there was a physical manifestation of the contract), with terms and conditions more or less clearly stated.  The normal minimum variables of a bond are: the name of the borrower (i.e. who is making the promise to repay), when it will be repaid (i.e. the maturity date) and in what form.  In addition most bonds bear a coupon, which is to say that they pay a regular amount of interest between the moment of receiving what was borrowed and eventually repaying it.  Beyond that there can be any number of additional features.  We may examine these elsewhere at other times, either in the glossary or in a blog post or two; but this is neither the time nor the place to do so.

CDO : CDO is the acronym of Collateralised Debt Obligation, which makes everything so much clearer.  It is perhaps self-referentially ironic that CDOs are actually notorious for their opacity.  CDOs are a form of securitization in which a pool or portfolio of existing bonds is used as the collateral for a brand new set of bonds, which is divided into seniority tranches.  The bonds in the portfolio provide the cash with which the CDO will pay interest and eventual the principal at redemption.  The clever additional feature is that the order in which we disburse the cash received from the portfolio bonds depends on the seniority of the CDO bond.  Thus the most senior tranche must be paid all the interest it is due before the second most senior tranche is paid; and the second most must be paid before the third etc. This clever prioritisation of payments is what allows for the alchemy of the transmutation of credits.  Indeed, suppose you own a number of different bonds, all of which are rated BBB (which is about as bad as you can get and still be eligible for most “serious” investment).  What is clear is that barring some very very unlikely catastrophe (so large that whether your bonds pay your interest will be the least of your worries, coming some way after “where will I find food to eat today?”), the great majority of your bonds will pay what they owe on time and in full.  This means that although before the fact there is a risk that some may not pay correctly (which is why they are rated BBB), after the fact you will observe that most (and quite possibly all) will have in fact paid as promised.  The problem is that before the fact you cannot know with certainty which ones will turn out to be OK.  This is the little conundrum that is solved by the CDOs scheme of prioritised payments.  And the alchemy is simply to note that if you own the most senior tranche of a CDO, you will get paid first, which means that you will get paid correctly with a degree of certainty close to total … which happens to be a close approximation of what is meant when we say that a bond is rated AAA.  In other words, by prioritising the order in which funds received from a pool of BBB bonds are paid out to the owners of different tranches of the CDO, you can ensure that the most senior tranche will, in fact, have the credit characteristics of a AAA bond. Et voila!

Coupon : A coupon is what you cut away from a piece of paper (newspaper, magazine or financial security such as a bond) to exchange against some advantage within a specified time period.  It may be exchangeable against three tins of baked beans at a cheaper price than prevailing; or against a sum of money (usually in a specified currency… or choice of currencies… or sometimes a commodity… or a choice of commodities), particularly if you have just cut it away from a bond.

Debt/GDP : This ratio is commonly applied to countries in order to get an idea of their solvency (in other words how likely they will be able to pay their debts).  GDP is a rough measure of a country’s income: it measures the value of all the goods (and services) produced in a country over a given period (which is usually one year). The debt measured is usually the consolidated gross central government debt (so, for example it would not include provincial debt in Canada). Although it is based on an intuitively attractive analogy with how we look at personal creditworthiness (i.e. against personal income) it is deeply flawed and is in fact an extremely poor indicator of potential default.  Just for a start, a government’s debt is not paid for by a country’s income, but by the government’s revenues.  The argument used to justify the GDP proxy is that it is an indication of the maximum potential income of the government, in the sense that the government’s revenues cannot exceed 100% of the country’s GDP.  A little though about what is likely to happen if a government’s tax rates even begins to approach 100% is enough to make one realise just how absurd is the construction of this ratio.  In passing we may wish to note that the highest debt/GDP ratio measured in an OECD country since 1900 is 767%, in Canada in 1946. Canada did not default. Unfortunately, although this ratio would never be taken seriously by a professional long-term investor in a country’s debt, it is taken seriously by enough unprofessional investors to be able to have short-term effects on a country’s ability to borrow. Far more serious than the ratio’s possibility of engendering short-term effects on government bond yields is the unfortunate fact that politicians all too often believe this nonsense measure, or at least claim to when it seems to justify their ideological dogmas. As such the debt/GDP ratio has a good claim to be one of the most destructive memes in contemporary finance.

Deflation : We all know about inflation, because most of us have lived through periods of “high” inflation.  These periods are when prices in the shops and elsewhere seem to rise quite quickly.  Less common are periods of deflation, which is when prices tend to drop.  Of course we know of individual products or types of product which seem to drop in price: computers or mobile phones are the obvious example.  But a generalised drop in prices across a wide cross-section of goods is considerably rarer; and is considered quite dangerous by policy makers.  In order to understand why, we need to engage in a little bit of thought experiment: if prices were dropping across the board in a meaningful way, you would undoubtedly continue buying your everyday products, such as food and toothpaste, but would you replace your car right away if you did not absolutely need too… if you had good reason to believe that it would cost you 20% less this time next year? So protracted deflation can be self-feeding: you put off your purchases, so the sellers of the goods you are not buying drop their prices further in an attempt to entice you to buy.  If this reflexive behaviour turns into a vicious cycle it is one that is difficult to break: we have a good idea how to break the vicious cycle of inflation, and central banks seem to do it very well when necessary.  If you put interest rates high enough you will slow growth and with it inflation.  It is like pulling on a string to drag a weight in one direction.  Unfortunately the inverse is not as effective: you cannot drop interest rates below a certain level (usually assumed to be zero, 0%): that weight that you could drag along by pulling on the string doesn’t seem to want to move when you push on it. Deflation is a big problem if it is accompanied by reduced activity: if enough people put off their purchases for long enough, economic activity will slow, unemployment increases, which itself leads to a drop in consumer spending. This engenders fears about the future, further dampening the likelihood of spending.  It is easy to see how this phenomenon could spiral out of control.  (Note that the scenario we are describing is accompanied by a drop in the velocity of money). But deflation is not necessarily an economic problem: it only becomes so if depressed economic activity and depressed prices are associated together.  If falling prices simply encourage consumption (which could easily be the case: do I put off getting a mobile phone because it may be cheaper next year?), then deflation can have a positive impact.  As noted in a post elsewhere, the UK went through a period of 100 years when prices were dropping one year in two, and overall prices dropped by almost 25%.  That period was one of protracted growth and optimism for the UK.  On the other hand, Japan has been experiencing protracted deflation for a good few decades now, and that period has been one of extremely low growth and general pessimism for Japan. As with so many concepts in finance and economics: it all depends… one the one hand things could go this way, but on the other hand…..

Eurobond (classical): Until recently there was only one clear connotation to the word “Eurobond”, and that was the one which Julius Strauss of Strauss Turnbull meant to give it when he coined the term.  He came up with the designation at the time of the first Eurobond issue in 1963 “to replace the outdated foreign dollar bond description and to portray the Europeanisation of the market”.  Although there has always been some argument about the details, over time the word has come to refer to a bond issue initially widely internationally distributed outside the country of the borrower, by a syndicate of international banks from different countries and free of any withholding tax on principal or interest. Although some used to hold that the issue had to be in a currency other than the borrower’s own, and that it had to be listed in Europe, and that the bonds had to be uniquely in bearer form, times have changed, the market has evolved and the definition has evolved with it.  Essentially this form of Eurobond refers to an issue that is internationally distributed by a syndicated of banks and/or securities houses largely (but not exclusively) based in Europe. These Eurobonds do actually exist in reality, though perhaps no longer physically!

Eurobond (recent): More recently the term Eurobond has come to be applied to any number of schemes involving some form of joint borrowing by the sovereign members of the Eurozone (i.e. countries using the Euro as a currency). Although there are examples of predecessors to the EU (and in particular the EEC) borrowing with the joint and several guarantees of its member states over 30 years ago, apparently any modern version of such a structure seems to be beyond the pale; at least for the moment.  I believe that a form of such borrowing is well-nigh inevitable, but doubtless the powers that be will continue fiddling for awhile yet. These Eurobonds do not currently exist in reality, other, perhaps, than metaphysically; and there are arguments about even that!

Eurozone : The Eurozone is the name commonly given to the group of countries that have adopted the Euro (€), or more ridiculously “the single currency”.  ON the 1st January 1999 eleven members of the EU adopted the Euro: they were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Since then Cyprus, Estonia, Greece, Malta, Slovakia, and Slovenia have joined the original members .To date the Eurozone has only ever expanded in membership, and now (as of 1st July 2013) consists of 17 of the 27 EU members.  IN agreement with the EU Andorra, Monaco, San Marino and the Vatican have also adopted the Euro as their official currency and may issue their own coins. Kosovo and Montenegro have adopted it unilaterally, in somewhat the same way as has Panama the US Dollar (though Panama also uses the Balboa).

GDP : GDP is the acronym for Gross Domestic Product.  It is a rough measure of the value of a country’s production of goods and services in any given period. As a statistic it is a relatively recent construct, and few countries were actually compiling the relevant data before the end of the Second World War.  For purely practical reasons of data gathering and measurement, GDP estimates are likely to be revised once or twice in the relatively short-term (i.e. in the first six months after the period being measured).  But for methodological reasons entire time-series of GDP may be changed many years after the initial release. There may be any number of reasons for these changes, including the recategorisation of certain types of effort form non-productive to productive or otherwise.  For example is an unpaid carer (taking care for example of their aged parents) engaged in productive labour? In addition there is a very important distinction to be drawn between real and nominal GDP (particularly if we are looking at long periods).  Nominal GDP is what the current production would be worth right now.  Real GDP is measured after inflation: if the value of your production has increased over the past year by 10%, but prices rose by 5%, nominal GDP growth would be 10%, but real GDP growth would only be 5%.  What measure of inflation is used to convert from nominal GDP to real GDP is another matter for discussion…. But there is the concept of the GDP deflator, of which more later.

Paying agent : a paying agent is an organisation (usually a bank) that acts as the agent of a borrower to make payments on that borrower’s behalf.  For example if you lend to the United States by buying a US Treasury bond, you may be lending to the Treasury, but you will collect any interest and principal from the US Treasury’s paying agent, in the form of one of the 12 US Federal Reserve Banks.

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