Alternative investments refer to the many asset classes that fall outside the traditional definitions of stocks and bonds. Each alternative investment has unique characteristics that require a different approach by the analyst.

A contingency provision in a contract describes an action that may be taken if an event (the contingency) actually occurs. Contingency provisions in bond indentures are referred to as embedded options, embedded in the sense that they are an integral part of the bond contract and are not a separate security. Bonds that do not have contingency provisions are referred to as straight or option-free bonds.

A call option has value to the issuer because it gives the issuer the right to redeem the bond and issue a new bond (borrow) if the market yield on the bond declines. This could occur either because interest rates, in general, have decreased or because the credit quality of the bond has increased (default risk has decreased). The issuer will only choose to exercise the call option when it is to their advantage to do so. That is, they can reduce their interest expense by calling the bond and issuing new bonds at a lower yield.

Convertible bonds are typically issued with maturities of 5–10 years. They give bondholders the option to exchange the bond for a specific number of shares of the issuing corporation’s common stock. Regardless of the price of the common shares, the value of a convertible bond will be at least equal to its bond value without the conversion option. Because the conversion option is valuable to bondholders, convertible bonds can be issued with lower yields compared to otherwise identical straight bonds.

An alternative way to give bondholders an opportunity for additional returns when the firm’s common shares increase in value is to include warrants with straight bonds when they are issued. Warrants give their holders the right to buy the firm’s common shares at a given price over a given period of time. Including warrants, which are sometimes referred to as a “sweetener,” makes the debt more attractive to investors because it adds potential upside profits if the common shares increase in value.

The legal contract between the bond issuer (borrower) and bondholders (lenders) is called a trust deed, and in the United States and Canada, it is also often referred to as the bond indenture. A bond indenture or trust deed is a contract between a bond issuer and the bondholders, which defines the bond’s features and the issuer’s obligations. An indenture specifies the entity issuing the bond, the source of funds for repayment, assets pledged as collateral, credit enhancements, and any covenants with which the issuer must comply.

The provisions in the bond indenture are known as covenants and include both negative covenants (prohibitions on the borrower) and affirmative covenants (actions the borrower promises to perform). Affirmative covenants require the borrower to perform a certain action and do not typically restrict the operating decisions of the issuer. Common affirmative covenants are to make timely interest and principal payments to bondholders, to insure and maintain assets, and to comply with applicable laws and regulations.

The features of a fixed-income security include specification of the following:

– The issuer of the bond.
– The maturity date of the bond.
– The par value (principal value to be repaid).
– Coupon rate and frequency.
– Currency in which payments will be made.

Once a bond has been issued, the time remaining until maturity is referred to as the term to maturity or tenor of a bond. When bonds are issued, their terms to maturity range from one day to 30 years or more. Bonds that have no maturity date are called perpetual bonds.

Bonds that pay no interest prior to maturity are called zero-coupon bonds or pure discount bonds. Pure discount refers to the fact that these bonds are sold at a discount to their par value and the interest is all paid at maturity when bondholders receive the par value.

A put option has value to the bondholder because the choice of whether to exercise the option is the bondholder’s. For this reason, a putable bond will sell at a higher price (offer a lower yield) compared to an otherwise identical option-free bond.

Alternative investments include hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, primarily collectibles. Each of these alternative investments has unique characteristics that require a different approach by the analyst.

A repurchase agreement is an arrangement by which one party sells a security to a counterparty with a commitment to buy it back at a later date at a specified (higher) price. The repurchase price is greater than the selling price and accounts for the interest charged by the buyer, who is, in effect, lending funds to the seller with the security as collateral.

The repo margin or the haircut refers to the percentage difference between the market value of collateral security and the amount loaned. The Repo margin serves as an insurance to the lender in the event that the value of the security decreases over the term of the repo agreement.

When the loan involves only one bank, it is referred to as a bilateral loan. Bilateral loans are funds provided to a borrower by one lender. The primary obstacle associated with bilateral loans is that other business partners, not named in the bilateral loan agreement, aren’t restricted from obtaining additional loans.

Agency or quasi-government bonds are issued by entities created by national governments for specific purposes such as financing small businesses or providing mortgage financing. In the United States, bonds are issued by government-sponsored enterprises (GSEs), such as the Federal National Mortgage Association and the Tennessee Valley Authority. Some quasi-government bonds are backed by the national government, which gives them high credit quality.

Bridge financing refers to debt that is temporary until permanent financing can be secured. Bridge funding, also known as bridge financing, is a form of temporary, intermediate funding intended to cover a business’s short-term expenses until long-term funding is secured. If business owners need money fast so that they can continue their business’s operations, a bridge loan may be a viable option.

The par value of a bond is the principal amount that will be repaid at maturity. The par value is also referred to as the face value, maturity value, redemption value, or principal value of a bond. Par value is important for a bond or fixed-income instrument because it determines its maturity value as well as the dollar value of coupon payments.

When bonds are issued, their terms to maturity range from one day to 30 years or more. Bonds with original maturities of one year or less are referred to as money market securities while bonds with original maturities of more than one year are referred to as capital market securities.

Sometimes an entity is created solely for the purpose of owning specific assets and issuing bonds to provide the funds to purchase the assets. These entities are referred to as special purpose entities (SPEs) in the United States and special purpose vehicles (SPVs) in Europe. Bonds issued by these entities are called securitized bonds.

A sovereign bond is a debt security issued by a national government. Sovereign bonds are typically repaid by the tax receipts of the issuing country. Bonds issued by non-sovereign government entities are repaid by either general taxes, revenues of a specific project (e.g., an airport), or by special taxes or fees dedicated to bond repayment (e.g., a water district or sewer district).

Secured bonds are senior to unsecured bonds because they are backed by collateral. A secured bond is a type of bond that is secured by the issuer’s pledge of a specific asset, which is a form of collateral on the loan while unsecured loans are loans where lending happens without the backing of equal value collateral.

Convenience yield refers to the value of having the physical commodity for use over the period of the futures contract. If there is little or no convenience yield, futures prices will be higher than spot prices, a situation termed contango. When the convenience yield is high, futures prices will be less than spot prices, a situation referred to as backwardation.

A fiduciary call refers to the combination of a call with exercise price and a pure-discount, riskless bond that pays at maturity. A fiduciary call is a trading strategy that an investor can use, if they have the funds, to reduce the costs inherent in exercising a call option.

Futures contracts differ from forward contracts in the following ways:

– Futures contracts trade on organized exchanges. Forwards are private contracts and typically do not trade.
– Futures contracts are standardized. Forwards are customized contracts satisfying the specific needs of the parties involved.
– A clearinghouse is a counterparty to all futures contracts. Forwards are contracts with the originating counterparty and therefore have counterparty (credit) risk.
– The government regulates futures markets. Forward contracts are usually not regulated and do not trade in organized markets.

Settlement price refers to the average of the prices of the trades during the last period of trading which is set by the exchange. The settlement price is the average price at which a contract trades, calculated at both the open and close of each trading day, and it is important because it determines whether a trader is required to post additional margins.

There are three styles of exercise for callable bonds. They are as follows:

– American style (the bonds can be called anytime after the first call date).
– European style (the bonds can only be called on the call date specified).
– Bermuda style (the bonds can be called on specified dates after the first call date often on coupon payment dates).

These are only style names and are not indicative of where the bonds are issued.

The secondary market is where investors buy and sell securities they already own. It is what most people typically think of as the “stock market,” though stocks are also sold on the primary market when they are first issued. While some government bonds and corporate bonds are traded on exchanges, the great majority of bond trading in the secondary market is made in the dealer, or over-the-counter, market. Dealers post bid (purchase) prices and ask or offer (selling) prices for various bond issues.

The process by which financial assets (e.g., mortgages, accounts receivable, or automobile loans) are purchased by an entity that then issues securities supported by the cash flows from those financial assets is referred to as securitization. Securitization offers opportunities for investors and frees up capital for originators, both of which promote liquidity in the marketplace.

Securitization can provide a couple of benefits. The primary benefits of the securitization of financial assets are:

– Reduction in funding costs for firms selling the financial assets to the securitizing entity.
– Increase in the liquidity of the underlying financial assets.