CDS basis trade where CDS premium> swap spread -strategy?

CFA Level II Portfolio Management
#1

CDS basis trade where CDS premium> swap spread, i understand the strategy is to buy the bond and buy the CDS. Shouldn’t it be sell the bond and buy the CDS, as the assumption is that the markets will converge and the spread will move towards the middle??. Any takers…

#2

If CDS Spread > Bond Spread, sell bond, sell protection (positive basis trade)

If CDS Spread < Bond Spread, buy bond, buy protection (negative basis trade)

In practice, negative basis trades are the only ones that really occur (given it’s tough to short cash bonds outside govies)

#3

Thanks Ro424, but i was really after an explanation or intuition as to why we buy bond and buy CDS???..Could you provide some further details.

#4

Assuming we’re talking apples to apples, your example is incorrect.

“If CDS Spread < Bond Spread, buy bond, buy protection (negative basis trade)”

For example, CDS Spread = 75, bond spread = 100

I buy the bond, i earn 100bps p.a.

I buy protection on the bond, i pay 75bps p.a.

In theory, i have a “riskless” position that nets me 25bps p.a. (100bps i earn on bond less 75bps in premium i pay for protection)

#5

The way I remember it (ignoring some risk like duration and counterparty risk on the cds):

If you buy a bond and buy a CDS(insurance), you are close to risk less

So Bond - CDS = RIsk free rate

rearranging… Bond - RFR (which is definition of bond spread) - CDS should be equal to 0

if bond spread > CDS spread, you will make money by holding this portfolio