Bond Glossary

What is an Economic Depression?

An economic depression refers to a period of severe economic deterioration.  While there is no true definition for a depression as there is for a recession, it can be characterized as a period with many of the following characteristics:  unemployment rates jump dramatically (typically into double digits), GDP takes a dive (10% or more), bank lending dries up, high levels of corporate bankrupcies, and an overall tightening of all trade and consumption.
 

The Great Depression

The most notable depression in the history of the United States is the Great Depression of the 1930's.  It was kicked off in October of 1929 with the great crash in the stock market and spread throughout the rest of the world in an expeditious manner.  Some blame a massive level of speculation in the stock market and an absence of a middle class for leading factors.  This uneven distribution of wealth led to an unstable condition where manufacturing output was outpacing demand for goods and services.  The roaring 20's masked this problem in a sense as the stock market was in a major bull market run which abruptly came to a halt when the market became overheated with excessive speculation by the masses.  Once the crash of 1929 hit, a majority of low income and middle income Americans lost their purchasing power overnight.  As the consumer fell, so did the rest of the economy.  Unemployment rates were at 25%, many were homeless, banks stopped lending, prices severely deflated, warehouses became stockpiled with oversupply while manufacturing came to a near halt. 

What is a Tranche?

A tranche identifies a slice of a security (typically a bond or other credit linked security) which is funded by investors who assume different risk levels within the liability structure of a security.  This risk can come in the form of a variety of factors; term to maturity, geographic exposure, and even repayment tiers.  Tranche's essentially describe the repayment risk that an investor is willing to take; with the higher risk investors receiving higher yields.

Tranche Tiers

Tiered tranches typically repay investors sequentially from highest rated to lowest rated, this is commonly known as "waterfall" since payments flow down from highest to lowest.  There are typically three major tranche tiers; Senior and Mezzanine, and Equity.  They can be distinguished by their credit ratings; for example, senior tranches are classified as triple A rated debt while mezzanine is AA to BB, and equity is considered "toxic waste" or unrated.  In the event of a default, it is highly unlikely that the equity holders will be repaid.  In most cases, senior tranches consist of risk averse entities such as pension funds, insurance companies, and conduits.

In the case of certain securities, such as the synthetic CDO, a super senior tranche also exists. 

Benefits of Tranches

Without tranching, investors would not be able to expose themselves to different levels of risk; it would be an all or nothing proposition.  Tranches allows risky investors to purchase the risk portion of the security while allowing investors looking for safehaven to buy into the highly rated portion of the security.

Disadvantages of Tranches

There are a few which have been brought to light during the credit crisis.  First, they are very complex; most investors do not really understand the risks associated with each tranche.  Tranches can be tiered, adding more complexity and rules around each possible scenario under worst case assumptions.  Again, most investors will not do their due dilligence.  We have seen a failure in understanding these tranched structures at the highest levels.  Credit agencies like Standard and Poors and Moody's failed to properly account for the massive risks that were inherent in most of these credit linked securities.  These agencies were providing triple A ratings to tranches within securities which were very close to defaulting.

What is the Secondary Market?

The secondary market is a forum where investors can buy or sell securities to/from other investors rather than directly from the issuer of the security.  The primary market is where securities are actually created; issuances can be made through IPO's, savings bond purchases, or even corporate bond issuances.
 
Secondary markets exist for stocks, bonds, mortgage backed securities, mortgages, and even derivatives such as collateralized default obligations.  Some of the most commonly known secondary markets are the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), Chicago Mercantile Exchange (CME), Nasdaq, and the New York Mercantile Exchange (NYMEX).

Auction vs Dealer Market

When you buy or sell a stock from your online broker; you are trading in the secondary markets.  They are essential to creating efficient capital markets through efficiency and transparency.  Transactions are being completed through one of two methods; an auction style exchange or a dealer exchange. 

In an auction market, buyers and sellers will converge and place offers to buy and sell.  These are commonly known as bid and ask.  The buyer is bidding to buy a security at a certain price while the seller is "asking" a certain price to sell their security.  The most aggressive buyer and seller have the best chances at executing their trade.  The most popular example of an auction market is the New York Stock Exchange where there are traders on the floor (specialists) who are buying and selling securities with each other, electronically, or through the phone. 

A dealer market is very similar in that the role of this market is to create liquidity and efficiency.  Dealer markets, as readily seen on the Nasdaq, have market makers who keep an inventory of the security and then transact with customers with that inventory.  Dealers will profit off of the bid/ask spread and the commissions charged to place the trade.