Here’s a trade. I’ve got these bonds, see? I will sell them to you. You will pay me $100 and get $100 face amount of bonds (if you like, you can get $80 or $120 face value of bonds, depending on where the bonds are trading – but let’s make them par bonds, to keep things simple).
But we’re not done. I will also write a contract under which, if these bonds default prior to maturity, you can hand them back to me, and I will give you back your $100. My loss will be the $100, minus whatever I can get from the defaulted bonds. In exchange for this commitment from me, you will pay me a running payment. That payment will be equal to (1) the coupon payment on the bonds (remember, they’re par bonds, for simplicity), minus (2) a risk-free rate of equal maturity, plus or minus (3) a basis driven by the cost of funding and differences in relative demand for different sorts of payments. Let’s say the bonds pay 6%, the relevant risk-free rate is 2%, and our funding costs are 50bps. Then you pay me 350bps running. The payments, and the contract, expire at maturity of the underlying bond.
Ah, but you have an objection. You’re paying me this running payment in exchange for my promise to cash you out if the bonds default – but how do you know I’m good for it? Fair. Why don’t we do this. I will collateralize that promise. At first my collateral will be quite small, since default is unlikely so the expected value of my promise is small, but it will go up if the bonds decline in value and/or my credit deteriorates.
Okay, fine, now we’ve got a deal. So … what is our deal? I’ve sold you bonds in a spot sale – that much seems clear – and we’ve got … this other thing, this contract. What do we call that contract?
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