A five year corporate bond yields 6.20% while the five year swap rate is 4.00%, and five year credit default swap protection on the same issuer trades at 190 basis points. Compute the basis, name the trade it suggests, and state the funding condition that has to hold.

A five year corporate bond yields 6.20% while the five year swap rate is 4.00%, and five year credit default swap protection on the same issuer trades at 190 basis points. Compute the basis, name the trade it suggests, and state the funding condition that has to hold.

Approach: Convert the bond yield into a spread over swaps, subtract it from the credit default swap level, then work through how the cash leg of the resulting trade is financed to maturity.

-30. The bond's spread over swaps is 6.20% less 4.00%, or 220 basis points, which approximates its z-spread, and the credit default swap is 190, so the CDS-bond basis is 190 less 220. A negative basis says the cash bond is cheap to the derivative, and the trade is to buy the bond and buy protection, locking about 30 basis points of carry with the default risk hedged. It only works if the bond can be financed at or inside the swap rate for the life of the trade, because the position earns a spread over its funding rate and 30 basis points of repo funding cost erases all of it. The residual exposures are counterparty risk on the protection seller, the mismatch between the deliverable basket and the bond held, and mark to market on the basis itself, which widened past 250 basis points in 2008 and forced funded holders out at the worst level.

Follow-up: The bond trades at 85 rather than par. Why does that move the basis mechanically, and in which direction?

Key concepts: CDS-bond basis, negative basis trade, repo funding, counterparty risk, z-spread.