What is the CDS basis, and why might it be negative or positive? How can traders exploit it?

The CDS basis is one of the most nuanced topics in CFA Level II credit analysis. It reveals the difference between the credit market's view (CDS) and the cash bond market's view of the same issuer's credit risk.

Definition

CDS basis = CDS spread - Z-spread (or ASW spread) of the cash bond

• Positive basis: CDS spread > bond spread. Protection costs more than the credit risk priced into the bond.
• Negative basis: CDS spread < bond spread. Protection is cheaper than what the bond market implies.

In a frictionless world, the basis should be zero. In reality, it fluctuates due to supply/demand imbalances, funding costs, and structural differences.

What Drives the Basis?

Key Drivers Explained

1. Funding costs: To buy a bond, you need to finance it. If funding is expensive (repo rates are high), cash bonds appear less attractive, pushing their yields up relative to CDS spreads. This creates a positive basis.

1. Cheapest-to-deliver option: In a CDS contract, the protection buyer can deliver the cheapest eligible bond upon default. This delivery option has value, making CDS protection worth more than a single bond's spread. This pushes the basis positive.

1. Counterparty risk: CDS protection is only as good as the protection seller's ability to pay. If the seller might default too, the CDS is worth less, pushing the basis negative.

1. Supply/demand dynamics: During crises, many investors rush to buy CDS protection (demand surge), driving CDS spreads above bond spreads (positive basis). Conversely, structured credit vehicles selling protection can push CDS spreads below bond spreads (negative basis).

Basis Trading Strategies

Negative Basis Trade (the 'free lunch'):

When the basis is negative (CDS < bond spread):

• Buy the cash bond (earn the wider spread)
• Buy CDS protection (pay the narrower spread)
• Net carry = bond spread - CDS spread > 0

Example with Kensington Industrial Group (fictional):

• Bond Z-spread: 250 bps
• CDS spread: 200 bps
• Basis: -50 bps
• Strategy: Buy bond + buy protection = earn 50 bps carry with (theoretically) hedged credit risk

Positive Basis Trade:

When the basis is positive (CDS > bond spread):

• Short the cash bond (or use a total return swap)
• Sell CDS protection (collect the wider spread)
• Net carry = CDS spread - bond spread > 0

Why 'Risk-Free Arbitrage' Isn't Really Risk-Free

1. Funding risk: The cash bond position needs financing that may become expensive or unavailable
2. Basis can widen further: A -50 bps basis can move to -150 bps, creating mark-to-market losses
3. Restructuring mismatch: CDS and bond may define 'credit event' differently
4. Maturity mismatch: The CDS and bond might not have identical maturities
5. Counterparty risk: Your CDS seller might fail (as happened with Lehman Brothers in 2008)

Exam Tip: The CFA exam typically asks you to identify whether a basis is positive or negative, explain a driver, and describe the appropriate trade. Remember that the negative basis trade (buy bond + buy protection) is the 'textbook' basis trade, and it earns positive carry when the basis is negative.

Explore credit derivatives in depth in our CFA Level II fixed income materials.