Credit default swaps (CDS) are not just a hedging tool for bank loan portfolio managers - CDS are being used by bond investors to create unique relative value investment strategies.

In particular, investors are discovering that the relationship between CDS prices and asset-swapped bond spreads can periodically offer attractive arbitrage opportunities. The difference between a bond's asset swap spread and CDS premium (i.e. cost of purchasing credit protection) is referred to as the CDS basis. If the CDS premium is less than the asset-swapped bond spread, the basis is described as negative.

Here is how a negative basis trade typically works:

• An investor buys a cash bond. If it is a fixed rate bond, the investor asset swaps the bond to earn a base floating rate of interest (such as BA's) plus a fixed spread. The asset swap allows the investor to gain exposure to the bond's credit risk while minimizing any interest rate risk.







• The investor then buys credit protection via a CDS to hedge the credit risk of the bond issuer. If the bond issuer experiences a credit event (typically specified as bankruptcy, failure to pay, or restructuring) during the life of the credit default swap, the investor can deliver the bond to the CDS counterparty (BMO) for payment at par.







• The net return to the investor will be the asset-swapped floating rate earned on the bond minus the cost of the CDS. In this example the net rate equates to 3-month BA's plus 25 bps. The investor has effectively replaced his credit exposure to the bond issuer with counterparty risk to BMO under the interest rate and credit default swaps, i.e. the investor is exposed to BMO in the event the bond issuer defaults.

We recently executed a number of negative basis trades for clients involving auto companies when bond spreads were trading significantly wider than the CDS cost of protection. Investors were typically able to earn net spreads in excess of 25 bps after hedging both their interest rate risk and credit risk. This net spread offered a very attractive return for the risk resulting from this combination of transactions, i.e. a better than senior bank debt spread for assuming credit risk exposure that is meaningfully lower than direct bank exposure since the investor only looks to the bank CDS counterparty if the bond issuer fails.

Negative basis opportunities arise from time to time, but tend not to last for very long – investors who are able to act quickly are the big beneficiaries. We are active in the market, highlighting negative basis trade ideas for interested investors.