Get Positive Results With Negative Basis Trades

It always seems like there is a trade du jour that certain market conditions, new products, or security liquidity issues can make particularly profitable. The negative basis trade has represented such a trade for single corporate issuers. In this article, we explain why these opportunities exist and outline a basic way to execute a negative basis trade.

What Is Basis?

Basis has traditionally meant the difference between the spot (cash) price of a commodity and its future's price (derivative). This concept can be applied to the credit derivatives market where basis represents the difference in spread between credit default swaps (CDS) and bonds for the same debt issuer and with similar, if not exactly equal, maturities. In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller than the bond spread.

When a fixed-income trader or portfolio manager refers to spread, this represents the difference between the bid and ask price over the treasury yield curve (treasuries are generally considered a riskless asset). For the bond portion of the CDS basis equation, this refers to a bond's nominal spread over similar-term treasuries, or possibly the Z-spread. Because interest rates and bond prices are inversely related, a larger spread means the security is cheaper.

Fixed-income participants refer to the CDS portion of a negative basis trade as synthetic (because a CDS is a derivative) and the bond portion as cash. So you might hear a fixed-income trader mention the difference in spread between synthetic and cash bonds when they are talking about negative basis opportunities.

Executing a Negative Basis Trade

To capitalize on the difference in spreads between the cash market and the derivative market, the investor should buy the "cheap" asset and sell the "expensive" asset, consistent with the adage "buy low, sell high." If a negative basis exists, it means that the cash bond is the cheap asset and the credit default swap is the expensive asset (remember from above that the cheap asset has a greater spread). You can think of this as an equation:

$\text{CDS basis} = \text{CDS spread} - \text{bond spread}$CDS basis=CDS spread−bond spread

It is assumed that at or near bond maturity, the negative basis will eventually narrow (heading toward the natural value of zero). As the basis narrows, the negative basis trade will become more profitable. The investor can buy back the expensive asset at a lower price and sell the cheap asset at a higher price, locking in a profit.

The trade is usually done with bonds that are trading at par or at a discount, and a single-name CDS (as opposed to an index CDS) of a tenor equal to the maturity of the bond (the tenor of a CDS is akin to maturity). The cash bond is purchased, while simultaneously the synthetic (single-name CDS) is shorted.

When you short a credit default swap, this means you have bought protection much like an insurance premium. While this might seem counterintuitive, remember that buying protection means you have the right to sell the bond at par value to the seller of the protection in the event of default or another negative credit event. So, buying protection is equal to a short.

While the basic structure of the negative basis trade is fairly simple, complications arise when trying to identify the most viable trade opportunity and when monitoring that trade for the best opportunity to take profits.

Market Conditions Create Opportunities

There are technical (market-driven) and fundamental conditions that create negative basis opportunities. Negative basis trades are usually done based on technical reasons as it is assumed that the relationship is temporary and will eventually revert to a basis of zero.

Many people use the synthetic products as part of their hedging strategies, which can cause valuation disparities versus the underlying cash market, especially during times of market stress. At these times, traders prefer the synthetic market because it is more liquid than the cash market. Holders of cash bonds may be unwilling or unable to sell the bonds they hold as part of their longer-term investment strategies. Therefore, they might look to the CDS market to buy protection on a specific company or issuer rather than simply sell their bonds. Magnify this effect during a crunch in the credit markets, and you can see why these opportunities exist during market dislocations.

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.