Like swaps on interest rates and foreign currency, credit swaps outstanding dwarf the underlying bonds in circulation.
First, lower rates will prompt homeowners to refinance, increasing prepayment speeds and lowering the value of the underlying bonds.
The culprit is the constant fluctuation in real yields, which means the prices of underlying bonds are changing as well.
He has warned government-bond dealers that the Fed expects them to make a market in repos, just as they do on the underlying bonds.
The first salvo was last month's proposal by the European Union to ban so-called naked credit-default swaps those in which buyers don't own the underlying bonds.
Such conduct caused municipal issuers to file inaccurate reports with the Internal Revenue Service and placed the tax-exempt status of the underlying bonds in jeopardy.
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Instead of buying corporate bonds, for example, Salient sells credit-default swaps, which are contracts under which his investors agree to pay the buyers if the underlying bonds default.
By separating a portfolio of derivatives into different tranches, banks can create virtually default-proof securities for conservative investors--if somebody else is willing to buy riskier "equity" tranches whose value vaporizes when as few as one or two of the underlying bonds default.
Market makers are not able to buy or sell the underlying corporate bonds because volume mismatches occur between ETF trading and underlying security trading.
These are often more difficult to trade, especially when part of the job requires securing and creating baskets of the actual underlying stocks, bonds, preferreds, currencies and futures.
Some market makers, called authorized participants (APs), are allowed to interchange ETF shares for their underlying securities, corporate bonds in this case.
If anything, the underlying demand for Treasury bonds is rising.
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Now that the rating agencies are downgrading CDOs as well as the underlying mortgage-backed bonds that they reference, it seems all but certain that banks and others will be forced into another round of markdowns.
Kramer notes these assets are most likely bonds and the underlying entity has to pay interest to the bond holder.
Underlying the rate worries, bonds -- whose fixed return makes them linked to interest rate and inflation expectations - also weakened.
The key is the amount of trading in the ETF's underlying elements, be they stocks, bonds, commodities or currencies.
CDOs offer higher yields than similarly rated mortgage-backed bonds, but are more susceptible to losses if the underlying loans decay.
The bonds initially were issued at a price that represented about 60% of the fair market value of the airliners being leased, meaning an investor buying the bonds at 70 cents on the dollar is getting the underlying collateral for about 40% of its original market value.
One key difference from the current system, which involves selling the underlying loans to Fannie Mae and Freddie Mac is that, with covered bonds, the loans stay on the balance sheets of the banks.
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