The CDS‐bond basis

• Date: 01 June 2019
• Author: Jennie Bai,Pierre Collin‐Dufresne
• Published date: 01 June 2019
• DOI: http://doi.org/10.1111/fima.12252

DOI: 10.1111/fima.12252

ORIGINAL ARTICLE

The CDS-bond basis

Jennie Bai1Pierre Collin-Dufresne2

1Departmentof Finance, McDonough School of

Business,Georgetown University, Washington,

Districtof Columbia

2Departmentof Finance, Ecole Polytechnique

Federalede Lausanne, Lausanne, Switzerland

Correspondence

JennieBai, Department of Finance, McDonough

Schoolof Business, Georgetown University,

Washington,DC.

Email:jennie.bai@georgetown.edu

Abstract

We investigate the cross-sectional variation in the credit default

swap (CDS)-bond bases and test explanations for the violation of

the arbitrage relation between cash bond and CDS contract, which

states that the basis should be zero in normal conditions. The evi-

dence is consistent with “limits to arbitrage” theories in that devia-

tions are larger for bonds with higher frictions as measured by trad-

ing liquidity, funding cost, counterparty risk, and collateral quality.

Surprisingly, we find the basis to be more negativewhen bond lend-

ing fee is higher suggesting that arbitrageurs are unwilling to engage

in a negative basis trade when short interest on the bond is high.

1INTRODUCTION

Financial marketsexperienced tremendous disruptions during the 2007–2009 financial crisis. Credit spreads across all

asset classes and rating categories widened to unprecedented levels.1Perhaps, evenmore surprising, many relations

that were considered to be textbook arbitrage prior to the crisis were severelyviolated. For example, in the currency

markets, violations of covered interest rate parity occurred for currency pairs involvingthe US dollar (Coffey, Hrung,

& Sarkar, 2009). In the interest rate markets,the swap spread that measures the difference between Treasury bond

yields and Libor swap rates turned negative. In the interbank markets,basis swaps that exchange different tenor Libor

rates (e.g., three months for six months) deviatedfrom zero. In the inflation markets, break-even inflation rates turned

negative implying an arbitrage with inflation swaps (Fleckenstein,Longstaff, & Lustig, 2014). In the credit markets, the

credit default swap (CDS)-bondbasis that measures the difference between CDS spreads and cash-bond implied credit

spreads turned negative.

These anomalies suggest that such relations are not, in fact, arbitrage opportunities in the traditional textbook

sense. Indeed, arbitrage profits may be difficult to realize in practice. Many of these relations involve a fully funded

(e.g., cash) instrument and one or more unfunded derivative positions. Thus, counterparty risk of the derivative issuer

may have rendered the arbitragerisky. Furthermore, funding cost differentials between cash instruments and deriva-

tive positions mayhave made the arbitrage costly to implement for an investor requiring funding. In the latter case, the

arbitrageviolations persist due to “limits to arbitrage” such as the inability of arbitrageurs to raise capital quickly and/or

their unwillingness to take large positions in these arbitrage trades because of mark-to-marketrisk. These apparent

arbitrage violations provide an interesting opportunity to test several of the limits to arbitrage theories (e.g.,as sur-

veyedby Gromb & Vayanos, 2010).

c

2018 Financial Management Association International

Financial Management. 2019;48:417–439. wileyonlinelibrary.com/journal/fima 417

418 BAI ANDCOLLIN-DUFRESNE

Investment-grade Bonds

High Yield Bonds

(a)

(b)

FIGURE 1 Dispersion of the CDS-bond basis by credit rating: (a) Investment-gradebonds and (b) high-yield bonds

[Color figure can be viewed at wileyonlinelibrary.com]

In this paper, we focus on the CDS-bond basis that measures the difference between the CDS spread of a specific

company and the credit spread paid on a bond of the same company.Figure 1 plots the time series of the CDS-bond

basis for investment grade (IG) and high yield (HY) bonds. The plots indicate that the averagebasis for IG firms, which

usually hovers around −17bps prior to the crisis, fell to −243 bps, and the average basis for HY firms dropped from

12 to −560 bps. In addition, the bases for both IG and HY firms remain negative even after the financial crisis. At first

sight, a large negative basis smacks of arbitrage as it suggests that an investor can purchase the bond, fund it at Libor,