There always appears to be a trade du jour that might be extremely successful due to market circumstances, new goods, or security liquidity difficulties. For single corporate issuers, the negative basis transaction has represented such a deal. In this essay, we’ll discuss why these possibilities occur and go through a simple negative basis trade.
What Is Basis?
Historically, basis has been defined as the difference between a commodity’s spot (cash) price and its futures price (derivative).This notion may be used to the credit derivatives market, where basis indicates the difference in spread between CDS and bonds issued by the same debt issuer and with comparable, though not precisely equivalent, maturities. Basis may be positive or negative in the credit derivatives market. With a negative basis, the CDS spread is less than the bond spread.
A spread is defined by a fixed-income trader or portfolio manager as the difference between the bid and ask price on the Treasury yield curve (treasuries are generally considered a riskless asset).This refers to a bond’s nominal spread over similar-term treasuries, or potentially the Z-spread, for the bond component of the CDS basis equation. Because interest rates and bond prices are inversely connected, a wider spread indicates that the asset is less expensive.
Because a CDS is a derivative, fixed-income players refer to the CDS component of a negative basis deal as synthetic, and the bond portion as cash. When discussing negative basis possibilities, a fixed-income trader may cite the spread gap between synthetic and cash bonds.
Executing a Negative Basis Trade
To profit from the spread differential between the cash and derivative markets, the investor should purchase the “cheap” asset and sell the “expensive” asset, following the adage “buy low, sell high.” If the basis is negative, the cash bond is the cheap asset and the credit default swap is the costly asset (remember from above that the cheap asset has a greater spread).Consider the following as an equation:
TextCDS basis = textCDS spread – textbond spread CDSbasis = CDSspread bondspread CDSbasis=CDSspread−bondspread
It is believed that the negative basis would progressively shrink at or around bond maturity (heading towardthe natural value of zero).The negative basis trade will become more lucrative as the basis narrows. The investor may lock in a profit by buying back the pricey asset at a lower price and selling the inexpensive asset at a higher price.
The deal is often executed using bonds trading at par or at a discount, as well as a single-name CDS (rather than an index CDS) with a tenor equal to the maturity of the bond (the tenor of a CDS is akin to maturity).The cash bond is bought, while the synthetic (single-name CDS) is sold.
When you short a credit default swap, you are purchasing protection in the same way that you would pay an insurance premium. While this may seem contradictory, keep in mind that purchasing protection entitles you to sell the bond at par value to the seller of the protection in the case of default or similar negative credit event. Buying protection is therefore equivalent to going short.
While the fundamental structure of the negative basis trade is straightforward, problems occur when attempting to find the most feasible trading opportunity and monitoring that transaction for the greatest potential to profit.
Market Conditions Create Opportunities
Negative basis opportunities are created by both technical (market-driven) and fundamental factors. Negative basis transactions are often done for technical reasons since it is expected that the connection is just transitory and will soon return to a basis of zero.
Many individuals utilize synthetic goods as part of their hedging strategy, which may result in value differences with the underlying cash market, particularly amid market stress. Traders favor the synthetic market at this time because it is more liquid than the cash market. Cash bond holders may be hesitant or unable to sell their bonds as part of their long-term investment objectives. As a result, rather than just selling their bonds, they may resort to the CDS market to purchase protection on a certain firm or issuer. If you magnify this impact during a credit constraint, you can understand why these chances emerge amid market disruptions.
Nothing Lasts Forever
Since market dislocations or “credit crunches” create the conditions for a negative basis trade to be possible, it is very important for the holders of this trade to monitor the marketplace constantly. The negative basis trade will not last forever. Once market conditions revert back to historical norms, spreads also go back to normal, and liquidity returns to the cash market, the negative basis trade will no longer be attractive. But as history has taught us, another trading opportunity is always around the corner. Markets quickly correct inefficiencies, or create new ones.
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