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

• Author: Weina Zhang,Haitao Li,Gi H. Kim
• Published date: 01 August 2017
• Date: 01 August 2017
• DOI: http://doi.org/10.1002/fut.21845

The CDS-Bond Basis Arbitrage and the

Cross Section of Corporate Bond Returns

Gi H. Kim ,* Haitao Li, and Weina Zhang

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

1. INTRODUCTION

The credit derivatives markets have experienced tremendous growth during the past decade.

According to the Bank for International Settlements (BIS, 2010), the notional value of

outstanding credit derivatives by the end of 2007 was 58 trillion dollars, more than six times

that of the corporate bond market as shown in Figure 1. Credit derivatives have

fundamentally changed market practices in the investment, trading, and management of

credit risk. Traditionally, institutional investors, such as pension funds and insurance

companies, typically adopt a buy-and-hold strategy in their investments in cash corporate

bonds. Nowadays, speculators, such as hedge funds and proprietary trading desks of

investment banks, can easily long and short the credit risk of individual companies or

portfolios of companies using credit derivatives.

1

Gi H. Kim is from Warwick Business School, University of Warwick, Coventry, United Kingdom. Haitao Li is

from Cheung Kong Graduate School of Business, Beijing, China. Weina Zhang is from NUS Business School,

National University of Singapore, Singapore. The authors would like to thank Yakov Amihud, Warren Bailey,

Tarun Chordia, Bing Han, Robert Jarrow, Paul H. Kupiec, Thomas Noe, Jun Pan, Jayendu Shantilal Patel,

Neil Pearson, Marti G. Subrahmanyam, Stuart Turbnull, Jason Wei, Feng Zhao, and participants at the 2010

McGill Risk Management Conference, the FDIC-Cornell-University of Houston Derivative Securities and

Risk Management Conference, the 2010 China International Conference in Finance, the Junior Workshop at

Fourth Singapore International Conference in Finance 2010, and the 12th Conference of Asia-Pacific

Association of Derivatives for their helpful comments and suggestions. Zhang acknowledges a research grant

from Ministry of Education of Singapore’s Academic Research Fund with grant number R315000074112/

133. All remaining errors are ours.

JEL Classification: G10, G12

*Correspondence author, Warwick Business School, University of Warwick, Coventry CV4 7AL, United Kingdom.

Tel: þ44 (0)24 7652 3849, Fax: þ44 (0)24 7652 3779, e-mail: gi.kim@wbs.ac.uk

Received December 2016; Accepted December 2016

1

See Rajan, McDermott, and Roy (2007) and D’Arcy, McNichols, and Zhao (2009) for a review of the credit

derivatives markets.

The Journal of Futures Markets, Vol. 37, No. 8, 836–861 (2017)

© 2017 Wiley Periodicals, Inc.

Published online 23 February 2017 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21845

The single-name credit default swap (CDS) is the most liquid and popular product and

accounts for more than two thirds of all outstanding credit derivatives. Since its first

appearance in late 1990s, CDS has been widely used to “arbitrage”the mispricing of the

credit risk of the same company in the cash and derivatives markets through the so-called

CDS-Bond basis trade. The CDS-Bond basis (the basis hereafter) is defined as the difference

between the CDS spread of a reference firm and the spread of the firm’s cash corporate bond

with similar maturity. Many studies have shown that CDS and bond spread should follow a

co-integrated process since they measure the credit risk of the same company.

2

Investors can

easily arbitrage away non-zero basis if the two markets are expected to converge in the future.

When the basis is negative (positive), one can long (short) the underlying corporate bond and

buy (sell) CDS to bet on the narrowing of the basis. Since it is generally more difficult to short

corporate bonds, the negative basis trade has been more popular in practice.

Unlike standard textbook arbitrage, arbitrage in practice is always risky. Arbitrageurs in

the basis trade face a wide variety of risks. First, non-zero basis could be due to contractual

differences between cash bond and CDS and does not necessarily represent pure arbitrage

profits. Second, due to the well-known limits-to-arbitrage constraints of Shleifer and Vishny

(1997), arbitrageurs could lose money even in potentially profitable trades. For example,

levered arbitrageurs in the basis trade could face funding liquidity risk. Arbitrageurs could

also face counterparty risk, mostly from sellers of CDS contracts, liquidity risks in both bond

and CDS markets, as well as deleveraging risks from other levered players. Therefore, in

practice, the basis trade is never a pure arbitrage, but a risky investment with its own risks and

rewards.

The huge losses in the basis trade suffered by Deutsche Bank, Merrill Lynch, Citadel,

and others during the 2007–2008 financial crisis highlight the risks involved in this trade.

The equal- and value-weighted index of the basis for investment grade bonds in Figure 2

exhibit wild fluctuations during extreme market turmoil in 2007 and 2008. The widening of

the negative basis was further accelerated by the unwinding of levered arbitrageurs due to

heightened uncertainty and their funding constraints, creating significant disruptions in the

FIGURE 1

The Size of CDS and Corporate Bond Market

This figure displays the time trend of the outstanding notional amount of the credit default swap (CDS)

and Corporate Bond market from December 2004 to June 2009 from Bank of International Settlement.

The three data series represent the amount of the CDS contracts, the single-name CDS contracts, and

the corporate bonds, respectively. [Color figure can be viewed at wileyonlinelibrary.com]

2

Hull, Predescu, and White (2004), Norden and Weber (2004), Blanco et al. (2005), and Alexopoulou et al. (2009)

among others have examined the parity relation between CDS and corporate bond spread.

Cross Section of Corporate Bond Returns 837