Basis trade for credit default swap

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?

Do I make sense?

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Not a CDS trader but here is my understanding:

Basis = CDS(spread) - Bond(Z-spread)

  • Positive Basis means CDS(spread) > Bond(Z-spread)

  • Negative Basis means CDS(spread) < Bond(Z-spread)

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.

=> Gain = 140 - (80+30) = 30bps

Hope this helps.