Bond-CDS basis keeps investors interested

Difference between cash bond spreads and derivatives narrows but still offers value, dealers say

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Investors have continued to take advantage of differences between cash bonds and their derivatives, dealers say, as the basis remains high after its historic blowout amid March’s volatility.

The bond-CDS basis measures the difference between a bond’s credit spread and the spread of the comparable credit default swap. With the basis on both investment-grade and high-yield debt reaching record levels in March, investors could buy the bond and corresponding credit protection, wait for the basis to revert to its historical average, and lock in what was essentially a risk-free return.

“It’s been a very popular trade for the last few weeks and remains an area of focus for investors, whether buying bonds outright or as a basis package, hedged against single-name CDS or index. It’s one risk premium that’s left to be captured in the market, has lagged the normalisation seen in other risk assets, and that should be still supported by the ongoing technicals,” says Laurent Samama, head of flow credit trading Europe at BNP Paribas, speaking in early June.

US credit has seen the biggest absolute spread movement. The bond-CDS basis is typically negative for US credit, which means spreads on CDS are lower than the equivalent bond spread. In March the basis spiked at -401 basis points for US high-yield bonds – around eight times the weekly average basis since mid-2010, according to aggregated data of individual bond-CDS bases compiled by JP Morgan.

The basis for US investment grade credit peaked at -186 basis points, again around eight times its weekly average since mid-2010.

The basis has compressed in recent weeks, though. For high-yield and investment-grade US credit, the basis in early June stood at -69.8 basis points and -40.2 basis points, respectively, above the respective 10-year weekly averages of -51.6 basis points and -22.5 basis points.

With the opportunity for large gains receding, the trade may have lost its appeal for fast money investors such as hedge funds, but the trade is said to still be attractive for buy-and-hold investors.

“A lot of opportunistic investors positioned themselves for a normalisation from March into May. At this level, it’s now mostly a bank and a longer-term investment type of trade – either explicitly looking at the basis as an investment or just buying bonds because the relative spread is attractive,” says Samama.

The basis is calculated by subtracting the bond spread from the CDS spread. In the US credit markets, bonds are generally less liquid than CDS, and credit spreads have been higher, driving the persistently negative basis. In Europe, the basis is generally nearer to zero for high yield and above zero for investment grade bonds.

 

In March, bond spreads spiked as investors rushed to sell bonds, pushing prices lower and elevating yields. CDS spreads also rose due to investors seeking protection in the most liquid market they could find – but the movement eased faster than was the case for bond spreads. This caused the basis to remain wide.

“History has taught us that, in a crisis, investors are generally hungry for cash and it is very difficult to sell cash bonds, so the basis tends to increase,” says Michael Hattab, senior portfolio manager at asset manager LFIS.

The widening basis attracted interest from a range of market participants, not all of whom would typically have made these types of trades.

“We had a lot of interest in basis trades in late March, early April. At those times people could buy very negative basis, and I think more people got involved in it that might not have done so previously,” says Saul Doctor, a credit strategist at JP Morgan. “There has been much broader appeal with more traditional asset managers looking at the basis and putting on trades on the back of that.”

A credit trader at a European dealer agrees that the trade remains popular for investors because the basis is above levels seen earlier in the year.

For shorter-term investors especially, the basis trade ultimately depends on the ability to fund the position. Hedge funds have abandoned the trade in the past due to funding costs and slow-moving basis markets. Funding pressures in March and April may have kept some investors out of the market, says Samama, but abating pressure has since made the trade more economical.

Hattab says: “The future will depend on the sustainability over time of central bank actions and the overall recovery across markets. So far, basis levels remain attractive from an historical point of view, but they are in a sort of middle range between expectations of a quick, full recovery and fear of a second market shock.”

Editing by Alex Krohn