The CDS‐Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns

Abstract

We provide a comprehensive empirical analysis on the implication of CDS‐Bond basis arbitrage for the pricing of corporate bonds. Basis arbitrageurs introduce new risks such as funding liquidity and counterparty risk into the corporate bond market, which was dominated by passive investors before the existence of credit default swap (CDS). We show that a basis factor, constructed as the return differential between LOW and HIGH quintile basis portfolios, is a superior empirical proxy that captures the new risks. In the cross section of investment grade bond returns, the basis factor carries an annual risk premium of about 3% in normal periods. © 2017 Wiley Periodicals, Inc. Jrl Fut Mark 37:836–861, 2017

The CDS-Bond Basis: Negativity Persistence and Limits to Arbitrage

“…Our second argument is that arbitrage risk factors, which previously influenced bond prices through an arbitrage channel (Kim, Li and Zhang 2017), are no longer relevant during the post-crisis period. The results of regression (9) used to formally test Assumption 2 are summarized in Table 12.…”

“…Despite the puzzling fact that basis negativity persists long after the end of the financial crisis, very few studies focus on the post-crisis period. Kim, Li and Zhang (2017) do not study the basis determinants, but rather analyze the CDS-bond basis from a different angle, exploring the implications of arbitrage trades on corporate bonds' future returns. Using a regression model of the basis on the risk factors inherent to arbitrage activity, they split the basis into two parts.…”

“…In case of an economic downturn or of funding or liquidity difficulties, arbitrageurs may be unable to hold their portfolios and be forced to liquidate their position in both instruments, which may put downward pressure on bond prices. Kim, Li and Zhang (2017) provide empirical evidence that CDS-bond basis arbitrageurs' activity introduces sources of risk in the bond market, affecting bond returns. Duffie (1999) shows that the spread of a floating-rate note over a risk-free rate is equivalent to the price of a corresponding CDS with the same maturity.…”

“…The predicted basis variable PB can be used as a proxy of the global risk involved in the negative-basis arbitrage trade, as in the study by Kim, Li and Zhang (2017). These authors use the predicted basis as the main explanatory variable to analyze the impact of negative-basis arbitrage on the price of corporate bonds.…”

Proxy CDS Curves for Individual Corporates Globally

“…The relationship of CDS premium vs. corporate bond yield spread (risky bond yield minus riskless bond yield) of the same tenor has been the subject of many empirical studies, for example, Blanco, et al (2005) and Zhu (2006) confirmed a long-run parity relationship between the two credit risk measures. Kim, et al (2017) further investigated the basis (CDS premium vs. corporate bond yield spread) behavior to see whether basis arbitrage is possible. This line of studies again sheds light on whether a theory holds or arbitrage opportunity exists, but offers no practical answer to predicting CDS for corporates without traded bonds of comparable terms.…”