Mini Chapter Four
CDS Bond Basis
Credit default swap spread oftentimes is used interchangeably with the credit spread on a corporate bond. In theory bonds can be delivered on CDS contracts in case of a default which should imply that credit spreads and CDS spreads should not diverge as that could create arbitrage opportunities. For instance, if Credit spreads widen a lot but CDS doesn’t, arbitrageurs could buy the bond and buy CDS protection to earn the basis till maturity. In case of default, they can sell the bond at recovery value and get compensated for their loss by the CDS, earning the risk-free locked-in basis of the trade.
CDS vs Cash Bond basis can persist – Though simply described above, this arbitrage (CDS spreads tighter than bond credit spreads is called negative basis) is not easy to lock in for reasons like a) it’s expensive to source matching tenors on the bond and the CDS b) balance sheet constraints i.e. shortage of capital/higher funding costs eats into the arbitrage opportunity c) different investor playfields or mandates/market accessibility. Similarly, if CDS trades wider than bond credit spread (called positive basis), the inability to short the bond/borrow it on repo in a timely manner would make it challenging to lock in this basis and even if the repo is secured the risk of the bond going ‘special’ needs to be monitored.
Also, terms around reference obligations in a CDS contract are crucial in determining its level as a wider spectrum of cheapest to deliver instruments many of which could be illiquid would trade at a deeper concession to the liquid ones nudging the CDS spread higher.
