CDS-bond basis and bond return predictability

Abstract

We examine the predictive power of the CDS-bond basis for future corporate bond returns. We find that residual basis, the part of the CDS-bond basis that cannot be explained by a wide range of market frictions such as counterparty risk, funding risk, and liquidity risk, strongly negatively predicts excess returns. Controlling for systematic risk factors, including credit risk and liquidity risk, we find that a bond portfolio formed on the residual basis generates a significant abnormal bond return of 1.79% at the 20-day horizon. The abnormal returns due to the residual basis reflect mispricing rather than missing systematic risk factors. These results are robust to different horizons and sample periods and to the various characteristics of bonds. Overall, our results imply a beneficial role of CDS in the bond market as the existence of mispricing between CDS and bonds results in a subsequent price convergence in bonds.JEL Classification: G10, G12

The CDS‐Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns

“…12 Robustness checks show that other measures of bond spread do not significantly affect our results. 13 More details on the model and its estimation procedures can be found in a companion paper (Kim et al, 2016). reflection of the compensation for the risks in the basis trade, then investors should be compensated in future bond returns by arbitraging away the non-zero basis.…”

“…More details on the model and its estimation procedures can be found in a companion paper (Kim et al, ).…”

What drives corporate CDS spreads? A comparison across US, UK and EU firms

“…Finally, we complement the previous literature (Kim et al, 2016) by investigating the predictive power of the basis to study future price movements in the CDS market. Our findings validate that the CDS market dominates the information transmission process between the CDS and bond market, which is more prominent in the post-crisis period, and we find the mispricing between the two markets has significant predictive power in forecasting subsequent price movement in the CDS market.…”

“…Because CDS is essentially an insurance contract against the default of a firm's bond, the CDS and corporate bond markets should theoretically move in tandem, closely interacting with each other (Kim et al, 2016). Consequently, the basis should be closer to zero after ignoring some technical issues, such as market friction, and any violation of this relationship would represent a mispricing between the two markets.…”

The CDS-Bond Basis: Negativity Persistence and Limits to Arbitrage

“…Although the residual basis may not be fully devoid of market frictions or risk factors that are not specified in our empirical model, it is expected to be less noisy in capturing mispricing after removing well-known risks and measurable market frictions (Kim, Li and Zhang 2016).…”