I cant wrap my head around the concept of basis trade for credit default swap.
Basis trade attempts to take advantage of the difference between the credit default spread and the bond 's spread. However, I didnt understand what the formula is to determine if the spread is positive or negative and the implication behind each outcome. I am not sure if we should look at the difference between the two spreads to determine if we should buy a bond or sell it, and accordingly with the CDS spread as well.
On Investopedia, it says that CDS basis=CDS spread−bond spread. Does it mean that we sold the credit protection ( hence receiving the premium) and issued a bond ( hence paying coupon)? This would mean positive CDS basis? It means that we are receiving more than we are paying
Whereas if CDS spread is lower than the bond spread, in order to trade on this difference, we should buy the bond because its paying us higher and then buy on the CDS spread to receive protection?
Positive Basis Trade
Let’s assume,
Z spread = 40bps
CDS price= 60bps
Repo = 2% (Libor minus 10bps)
=> You will short the bond pay at 40bps and fund it in reverse repo at 2% or Libor minus 10bps and sell protection to receive at 60bps. (Note that the reverse repo position is below Libor at 10bps and it represents the interest income, therefore, this is the funding loss)
=> Gain = 60 - (40+10) = 10bps
Negative Basis Trade
Let’s assume,
Z spread = 140bps
CDS price= 80bps
Repo = 2% (Libor plus 30bps)
=> You will long the bond to receive at 140bps and borrow from repo at 2% or Libor plus 30bps and buy protection to pay at 80bps.
CDS basis is the difference between the spread you can earn by owning a corporate bond and the CDS spread on the same issuer.
We say that the basis is negative when spread on corporate bond is higher than CDS spread.
According to the convention the basis is (cash price- derivative price) and as a consequence the basis should be positive not negative. Probably because here the bond spread is logically supposed to be less the CDS spread of the same issuer.
Under normal conditions, both should be about the same since both reflect credit risk perception.
But discrepancies can exist when cash bond market faces liquidity constraints (hence illiquidity premium adds to the spread to compensate for owning such less liquid bonds) considering that CDS market is much more liquid.
Moreover this can also happen according to demand vs supply for such bonds. Higher supply meaning higher premium.
This is why quantitative easing can contribute to a less negative basis since the central bank buys bonds (increasing price and decreasing yield) but not CDS’s.
In fact you should see the reasoning under the perspective of insurance. Why buying an insurance if there is already an imbedded insurance in the product you bought.? You would pay twice for the protection.
And what about if the imbedded insurance in the product you paid offers a better protection than the insurance you would buy to the insurance company itself?
When holding the corporate bond provides you a return or spread even higher then the spread provided by the insurance (aka CDS) not only you don’t need the protection but you can become the insurer, selling the spread between both insurance’s price while self insuring yourself.
Result: you buy the bond and you sell the CDS when there is a negative basis that is higher spread on bond vs CDS of the same issuer.