Saturday, October 10, 2009

The saga of the CDS-bond basis trade

Last year saw the largest blow out of CDS-bond basis spread. A typical trade involved buying a bond, leveraging it, and buying protection on the name. The idea was that over time any spread between bond yield (less financing cost) and CDS would disappear over time. Given that it was a hedged trade (long credit and long protection), prime brokers provided significant leverage such as 20:1. But as funds went searching for liquidity with redemptions looming, they unwound the trade, forcing the basis spread to widen. As it widened, prime brokers asked for additional margin to support losses on the trade. Margin calls on the leveraged trades forced a spiral of unwinds, creating the largest widening of basis spread ever.

Earlier this year credit started to rally as the demand for corporate bonds picked up. The spread to CDS began to narrow again. But recently the narrowing has stalled. What happened?

The answer goes back to banks' balance sheets. In 2008 banks got jammed with LBO debt that they had commitments to finance. With the LBO craze of 07, billions in leveraged institutional loans and bonds that banks would normally be able to sell to CLOs and hedge funds ended up on their balance sheets. Some banks sold the debt at steep discounts and provided financing as they did so. Many had no choice but to hold it. The chart below shows corporate loans on banks' balance sheets spiking in 08.

Source: FRB

Being unable to unload the corporate debt didn't stop banks from reducing their risk by purchasing CDS protection. However this year the markets opened up and banks started dumping their positions. As they sold bonds and loans, they unwound the CDS protection, becoming net sellers of CDS. That forced CDS spreads to tighten, holding the CDS-bond basis from narrowing further.

Some expect this basis to resume its tightening as banks finish unloading the bulk of CDS they had bought. But it will not go back to flat for a while, simply because prime brokers no longer provide the leverage they used to. And without the leverage the basis trade just will not be profitable enough to make it worth while.

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