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Fixed Income and the Basis Trade Capital Structure

Fixed Income and the Basis Trade Capital Structure

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Published by: zerohedge on Nov 18, 2010
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12/27/2010

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The Bond-CDS Basis and a Fixed Income Conjecture

In a prior post, I wrote: “…credit has some nice features. The price-to-hopefulness ratio is never a part of valuation. Few have trouble parting with a bond when the price is right. There is a fuzzy but ever-present upside limit. There is a downside bounded by the recovery rate. There are simple opening lines: acquiring higher yield implies taking more risk by 1) lengthening term risk, 2) taking more credit risk, 3) moving down the capital structure, or 4) some combination.” [My bold] This is a pretty provincial view of fixed income trading, like chess theory before Nimzovich. The key concept to modern stochastic fixed income strategy is the rethink it requires regarding capital structure. Synthetic instruments have greater seniority than senior bonds, or at the least, capital structure is non-linear. The synthetic instruments to which I refer are credit default swaps. Understanding that credit default swaps are a way to step up the capital structure absorbs them into fixed income trading in a natural way. At the same time they opened up some terrific opening lines. One can basis trade based on the whether a CDS is priced rich (or no) against an underlying bond. One can trade dispersion, by selecting name(s) that outperform an index basket, or by selecting a CDS that outperforms another CDS. There is curve trading of same-name CDS at different maturities. I’m not going to go further, but the cap arb strategies can extend beyond the strictly fixed income space. That “sell VIX- buy CDS” arb is an example. The focus here is on the first opening line: basis trading. All this hypermodern thinking leads me to a conjecture about the peculiar behavior of the cash-CDS basis in a crisis. I’ve had some helpful comments and thoughts from some ego-free people about the subject. Special thanks to Cheng. Here’s the point. There is a theoretical equivalence between buying a bond and selling a CDS. Let me sketch this out in outline. A CDS is equal to buying a bond and swapping its cash-flow to floating. When the price is right, buying a CDS on a name with same maturity is a risk free portfolio (given certain assumptions). Given this, we can reconstruct a corporate bond (and define a CDS) in the following way: Long corporate bond = Risk-Free Rate + Swap Counterparty Risk Premium + Default Event Risk Premium + (Actual Recovery Rate – Assumed Recovery Rate) + Liquidity Risk Premium = short Credit Default Swap

The fact that basis traders exist and make money on the convergence reinforces this equivalence. There’s a problem, though. The basis trade arb doesn’t hold up in a crisis. See below.

This makes clear that CDS and bonds are not equivalent no matter what the theory says. Based on everything I’ve said so far, why would this be? I asked around the community about this: Why should buying cash or selling synthetic instruments fare differently in the face of large absolute moves? This is a good answer I got: One word: liquidity. If you buy a bond you need some funding, i.e. bind liquidity until maturity. Yes, you say you can get out anytime before, just sell the bond and go away, but if things turn sour people will sit on their cash like Scrooge McDuck and nobody will buy your bond. Thus the price drops and the bond-CDS basis skyrockets.

For CDS you have to post collateral but that can be anything your collateral agreement allows. I respect this answer and I know there is truth in it. But it probably isn’t the whole story. Also from a practical standpoint, not all risks can be hedged. Because of this, one has to deal with those risk premiums gone haywire. But this answer seems more like blaming the problem on a technical glitch. There is another, more straightforward factor to consider. This factor is the behavior of the cash-CDS basis in a crisis of confidence: investors move up the capital structure. Conjecture: There is an important difference between a CDS contract and a bond: in bankruptcy, derivatives are settled first, so they have effective seniority over cash instruments, unless those cash instruments are secured. Let’s me walk you through my logic. After Lehman, LIBOR funding shot up. This spike in funding costs could conceivably cause a cascade of defaults, and derivatives houses could potentially seize collateral and unwind trades on a scale not seen before. It was necessary for investors to react to this contingency. Investors could see what happened to Lehman’s unsecured creditors. They got screwed, because derivatives are settled before cash creditors can exercise collateral. If you as an investor know this and can’t get secured senior debt on a money center bank, then a CDS contract is at least as good, if not a better instrument (because of capital lock-up issues) to get exposure.

 

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