New York J.P. Morgan Securities Inc.
December 2, 1999 Fixed Income Research
Pearl Buenvenida (1-212) 648-0045
buenvenida_pearl@jpmorgan.com
Product Brief
Assessing Value between Credit Default Swaps and
Corporate Bonds
• We expect the credit default swap market to continue
its rapid growth
• Asset swap spreads provide an approximate link
between credit default swaps and the cash market
• Basis trades can capture relative funding advantages
and differences between the cash and derivative
markets
Market Overview
The credit derivative market has shown tremendous growth,
nearly doubling in size since the beginning of 1998. Latest
OCC Bank Call reports show that the outstanding notional
amount of credit derivatives has increased to $257.6 billion
in Q299, up almost $29 billion from the previous quarter.
Credit default swaps (CDS), with an estimated 1998
transaction volume of $300 billion, are the most common
form of credit derivative instrument. These structures are
receiving increasing attention from traditional cash
investors as a result of the poor liquidity witnessed
intermittently over the past year in the corporate bond
market. As a consequence, the CDS market has evolved
greatly this year, adding improved liquidity and two-way
pricing. For investment grade names, credit default swap
trades of $10 to 25 million in size have been commonplace
and have been absorbed with minimal disruption to the
market. Bid/offer spreads for single-name credit default
swaps have improved as well, tightening to approximately 6
to 12 bps (about twice typical cash bond bid/offer spreads).
Basic Description/Structure
Formally, credit default swaps transfer pure default risk.
These instruments involve a transaction between two
counterparties where the seller of protection receives a
periodic “fee” in return for making a lump sum payment if a
credit event were to befall the underlying reference entity
(Chart 1). The protection buyer, on the other hand,
decreases exposure to the reference entity, but assumes
contingent (“two-name”) exposure to the protection-seller.
(See The J.P. Morgan Guide to Credit Derivatives; and
Credit Derivatives: A Primer for a more detailed
explanation). Credit default swaps would thus appear
complicated on the surface and possess a conditional
element that could be difficult to price and hedge. We find,
however, these structures are less difficult to analyze than
they appear.
Chart 1
Basic credit default swap structure
Periodic Fee
Protection Protection
Seller
Buyer
Contingent
Payment
Valuing Credit Default Swaps
To value a CDS, simply consider the information and skills
needed in valuing a bond. We can decompose a bond’s cash
flows into two components: 1) an interest rate embedded
funding part that involves either no credit risk or a standard
level of credit risk like that associated with Libor, and 2) a
residual that carries the credit risk— both the spread
component and the recovery value in the event of a
default— of the bond. The cash flows of this residual
component can be shown to be identical in direction and
timing to that of a CDS for both default and no-default
scenarios. As Chart 2 shows, by deconstructing the bond
into its respective components, we find the cash flows of the
bond’s credit component match those of a protection seller
in the CDS market. This leads to the conclusion that the
credit default swap “fee” is precisely equivalent to the
bond’s credit exposure spread, and the bondholder is
implicitly a “protection seller.” Although the credit default
swap does have a contingent dimension that is a form of
option, this dimension is valued every time the underlying
bond’s credit exposure is valued.
Credit default swaps, independent of bonds, do create some
practical difficulties for “real money” investors that are
distinct from hedge funds. While writing protection in a
CDS replicates the spread over Libor that would be earned
from bearing the bond issuer’s credit risk, the investor still
needs to earn the funding component by investing the
principal. This involves the investor in an extra source of
credit risk because it is possible for both the Libor
counterparty and the original borrower to default
simultaneously. In reality, this simultaneous default
probability is very small. Nevertheless, the possibility of
default by two counterparties means that the “real money”
investor will be more exposed to counterparty risk.
New York J.P. Morgan Securities Inc. Credit Default Swaps and Corporate Bonds
December 2, 1999 Fixed Income Research page 2

Chart 2
The credit component of a bond is identical to a credit default swap
With a default in period 5:
spread

5-period Funding Credit Exposure Credit Default

spread
Bond Swap

fee
recovery
equals plus equals
principal

libor

principal

libor
Loss
in
default
lump sum
t= 0 1 2 3 4 5 t= 0 1 2 3 4 5 t= 0 1 2 3 4 5 t= 0 1 2 3 4 5

costs could implicitly achieve Libor funding by sourcing risk

This contrasts with a bond where the bond issuer would in
effect be the counterparty for both components. However,
by bundling the Libor funding with the credit default swap
so that a default by one counterparty cancels the investor’s
exposure on the other, an investor can replicate this
relationship within a bond and remove the dual counterparty
exposure. Because joint default occurs with very small
probability, this solution changes the cost of the structure
minimally and forms the foundation for assessing CDS
value relative to bonds through comparisons with asset swap
spreads.
Linking the Credit Default Swap and Cash Markets
Considering the link between the bond market and the CDS
market is of particular interest from a trading perspective.
To the extent that both markets are trading the same credit
risk, we should expect the prices of assets in the two markets
to be related. This proposal is further supported by the
observation that, similar to the interest rate swap market
where receiving is equivalent to being long a fixed rate bond
and short a Libor floater, selling protection through a CDS
also exactly replicates the cash position of being long a risky
floater paying Libor plus a spread and being short a riskless
floater paying Libor flat. Therefore, we should expect a
CDS to trade at the same spread as an asset swap of similar
maturity on the same credit.
through a CDS, as they typically would pay above Libor to
use their own balance sheet to purchase bonds.
Another reason for the prevalence of the basis lies in the
definition of the CDS contract. In a contract, a list of
obligations that can trigger a credit event and be delivered
against the swap in such a case means that if the reference
entity defaults on any outstanding bond or loan, a default
event is triggered and the protection seller must make the
contingent payment. Hence, the CDS spread will be based
on the spread of the most subordinated obligation. Since
many less liquid instruments trade at levels different to the
bond market, this can result in a CDS spread that differs
from the spreads in the bond market.
An approximate arbitrage relationship involving the bond,
funding leg and CDS ultimately ties these two markets
together and ought to keep the basis within certain limits.
For example, suppose the CDS trades at a level that is less
than the asset swap spread (Chart 3). An investor who locks
Chart 3
Credit default swap spreads cannot be much smaller than asset
swap spreads
CDS = 20 bps; swap spread = 30 bps
Funding
Source

In practice, however, we observe a basis between the CDS L+5 floating

funding cost CASH = par
market and the asset swap market, with the CDS market
typically trading at a higher spread (5 bps on average) than
the equivalent asset swap. Liquidity premia and market fixed coupon
segmentation can partially explain this basis. Currently, the = T+ 60bps T+60bps
Bond Interest Rate
Cash Swap CPY
bond market holds more liquidity than the CDS market, and Bond
Buyer
L+ 30bps
CASH = par
investors are willing to pay a premium and accept a lower
spread for this liquidity. Market segmentation occurs
because regulatory constraints prevent certain institutions
20bps Contingent
from participating in the default swap market even though Payment
they are allowed to source similar risk through bonds. As
an offset, certain market participants are more inclined to Credit Swap
CPY
use the CDS market. For example, banks with high funding
New York J.P. Morgan Securities Inc. Credit Default Swaps and Corporate Bonds
December 2, 1999 Fixed Income Research page 3

in funding a long bond position at Libor plus 5 bps can Chart 4

purchase the bond and asset swap that asset to receive Libor
Higher funding costs limit cash market returns for lower-
plus 30 bps, effectively eliminating the interest rate
rated investors
exposure. Purchasing default protection at 20 bps leaves the CDS = 20 bps; asset swap spread = 17 bps
investor with a positive income stream of 5 bps running in
an essentially risk free position. As the arbitrageur Asset swap returns:
continues to purchase both the bond and default protection High Quality Low Quality
to realize this income stream, the underlying’s credit default Institution Institution
swap and asset swap spread should be expected to converge. Asset swap
Libor + 17bp level
10bp
On the other hand, arbitraging a high CDS spread could in
theory involve selling protection through the credit default 27bp

swap and selling short the bond in the cash market.
Locking in the difference in spreads involves running this
short position until the maturity of the bond. If this were
possible through the repo market, the cost of funding this
position would be uncertain and the position has risk,
including the risk of a short squeeze if the cash paper is in
short supply. However, obtaining funding for term at a good
rate is not always possible. Even if the funding is achieved,
the counterparty on the CDS still has credit exposure to the
arbitrageur. The cost incurred by the counterparty to hedge
out this risk implies that the basis has to be big enough to
cover this additional cost. Once both of these things are
done, the arbitrage is complete and the basis has been
locked in. However, on a mark-to-market basis, the position
could still lose money over the short term if the basis widens
further. This is not currently an easy arbitrage to perform,
which explains why the basis can sometimes be substantial.
Implications of Investors’Funding Costs
Recall that for a CDS the protection seller does not have to
“put up collateral” in the same way as if purchasing a cash
asset. Therefore, the return for sourcing risk through a
credit default swap can be thought to merge a financing with
a credit risk position, with the investor effectively leveraged.
Because an investor’s realized net spread combines credit
plus funding, a CDS can be used to exploit relative funding
advantages. Institutions with low funding costs may
capitalize on their advantage through “basis trades” by
funding assets on the balance sheet and purchasing
protection on those assets. In particular, this is most
profitable in the event of a “negative basis.” A negative
basis between credit default swap and bond asset swap levels
exists when CDS trade inside of asset swap spreads.
Therefore, the premium for buying default protection could
be less than the net spread that can be earned over an
investor’s funding costs. As outlined in the previous
section, a low-cost investor can offset the risk of the
underlying credit but still retain a positive income stream by
asset swapping the bond and purchasing protection.
On the other hand, BBB-rated investors that asset swap
individual credits will likely achieve the lowest net spread
due to higher funding costs (Chart 4). Because the cost of
funding is indirectly relevant for CDS, credit default swaps
Libor
Libor+7
Libor-10
Credit swap returns:
High Quality Low Quality Cost of funding asset
Institution Institution
Spread over funding
20bp 20bp
are increasingly more attractive for lower-rated investors to
source risk versus the cash market. This is particularly the
case with “positive basis” opportunities, when a credit’s
asset swap spread trades inside of its credit default swap
spread. For instance, this situation can occur in cases where
little debt exists for a specific credit and the bonds trade
extremely rich due to high relative demand. Investors can
capture the benefit of a positive basis by selling protection in
the CDS market rather than sourcing risk in the cash
market, nearly replicating the credit exposure of cash bonds
but at an additional spread pickup. Furthermore, by
bundling the CDS together with interest bearing collateral, a
synthetic bond can be created that could draw a wide
premium to attainable cash market levels.
Conclusion
We expect the growth of the credit default swap market to
continue at a rapid pace. As the number of credits traded,
especially at the lower end of the credit spectrum, continues
to increase, we anticipate that even greater liquidity and
market participation will follow. Trading opportunities
linking corporate bonds and credit derivatives are a natural
step in this direction. These opportunities will be
particularly attractive for investors in negative basis
situations.
New York J.P. Morgan Securities Inc. Credit Default Swaps and Corporate Bonds
December 2, 1999 Fixed Income Research page 4

Addendum: Recent Behavior of Basis Trades

Negative basis trades are attractive for low-cost funders
For natural holders of corporate bonds, basis trades where 5-year Sears credit default swap vs. S 6.25% 1/04 asset swap
the investor is both long the corporate bond and long spread (bps)
protection present unique hedging and relative value 90
opportunities. In recent weeks, we have found that the CDS 80
market has traded in a way that makes it an imperfect hedge
70
for corporate bonds. As individual credits have
60
disappointed, spreads on the bonds have generally widened
more dramatically than the matching CDS. An investor that 50

had bought protection for an existing bond position in one of 40

these credits would have thus lost money due to the change 30
in the basis. Or put another way, to hedge the market move 20
rather than an actual default, the investor would have 10
needed to purchase more CDS than it had originally
0
appeared. We believe this disproportionate widening has 31-Mar-99 20-May-99 9-Jul-99 28-Aug-99 17-Oct-99
not been uniform among credits and has been highly
dependent on either the absolute level of the CDS or on the Bid Offer Asset Swap Spread
absolute level of the basis.
Source: J.P. Morgan Securities, Inc.
Basis trades, where the absolute level of the credit default
swap is small and the reference credit’s bonds can rally on subject to negative basis trades from low-cost funders who
an asset swap basis to the Libor flat or better level, exhibit a asset swap the bond and buy a nominal matched amount of
type of "convexity" that enters into the trade. In a market protection. If these low-cost arbitrageurs have a special-
rally, credit default swaps will find a floor somewhere above purpose vehicle that allows them to fund at Libor plus a
zero given the unlikelihood a protection seller would pay to spread off-balance sheet, they are able to do this negative
take on risk. Furthermore, we would expect some relative basis trade unlimitedly at a profit of the basis less their
spread should exist between credits of differing quality, i.e., funding spread to Libor. This should result in a floor in the
presumably a triple-B credit should trade wider than a level of the negative basis— the more through the
double-A credit. Therefore, we should expect the floor for a arbitrageurs’funding level the basis trades, the stronger will
CDS to be above zero and increasingly so the further down be the "pull" back to that funding level. This is a soft target
the credit spectrum. 1 The bonds, on the other hand, are not and will depend on actual and expected access to funding as
prevented from rallying through that floor. As the CDS well as the willingness of low-cost funders to do this type of
approaches the floor implied by its credit quality, it trade. In short, once the basis moves against the investor to
effectively loses “duration” (its capacity to generate losses the point of the arbitrageurs’funding vehicle, we would
for the protection buyer diminishes in a continued spread expect to experience the arbitrageurs' actions, limiting losses
rally). As a result of the gains achieved through holding the on the downside.
bonds, the investor in the basis trade will be getting longer
in a rally— a type of positive "convexity." These observations suggest that even in a bullish spread
environment, basis trades on credits where protection is
Now consider the case where the absolute level of the basis cheap on an absolute level appear to display an excellent
is small and the market sells off. If investors who have convexity profile. In particular, we think doing these trades
implemented a basis trade have the foresight to see that this on credits that are relatively liquid in both the bond and
is the start of a market selloff, they can sell the bonds, CDS markets and where the basis is negative is a cheap
liquidity allowing, and be left with a short exposure through alternative from the point of view of macro-hedging a
being long protection. If, however, they are unable to do corporate bond portfolio. There is potential upside in a rally
this and as previous behavior implies, the bonds widen more and limited downside with the opportunity to take on a short
than the CDS, investors could still potentially benefit from exposure in a selloff. Additionally, the corporate
another “convexity” when a small positive basis becomes bondholder will be protected in the case of an actual default.
more and more negative. The underlying credit will be

1
We can think of this floor as the credit’s rock-bottom spread (see Valuing
Credit Fundamentals: Rock-Bottom Spreads, P. Rappoport, November 17,
1999)
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