What is CDS basis and how do positive vs negative basis trades work?

Question

AcadiFi · Accepted Answer

The CDS-bond basis is the difference between a reference entity's CDS spread and the credit spread on its cash bond of similar maturity: Basis = CDS Spread − Bond Z-spread. In theory, no-arbitrage suggests basis should be zero because owning a bond and buying CDS protection creates a synthetic risk-free asset. In practice, basis deviates due to funding costs, counterparty risk, contract specifics, and liquidity. ```mermaid flowchart LR PB[Positive
Basis] -->|CDS > Bond| SC[Sell CDS
Short Bond] NB[Negative
Basis] -->|CDS < Bond| BB[Buy Bond
Buy CDS] BB -->|Risk-free
Pickup| P[Profit] ``` Negative basis trade (CDS cheaper than bond): Bryant Capital buys Mercado Textiles 5-year bond yielding Treasuries + 400 bps, and buys 5-year CDS protection at 350 bps. Net carry of +50 bps with supposedly no credit risk (bond hedged by CDS). Risks: funding spread widening, CDS counterparty default, bond cheapest-to-deliver issues, and basis widening further before convergence. Positive basis trade (CDS expensive relative to bond): sell CDS protection and short the bond. This is harder due to bond borrow costs and is less common. Drivers of basis: (1) bond specialness in repo (negative funding shortages push basis negative), (2) counterparty risk in CDS (pushes CDS spread down relative to bond), (3) restructuring clauses (CDS may pay on restructuring, bond doesn't), (4) supply-demand imbalances (hedgers crowding CDS), (5) accounting/capital treatment differences. During 2008-2009, basis hit −400 bps on some names as bond prices crashed faster than CDS widened. Hedge funds captured massive returns when basis normalized. This is classic relative value credit trading tested on CFA Level III.

What is CDS basis and how do positive vs negative basis trades work?

Master Level III with our CFA Course

Related Questions

Practice Questions