Tuesday, March 2, 2010

On the non-existent basis of a (Greek) CDS ban

Original posted on FT Alphaville by Tracy Alloway

Citigroup analysts, led by Michael Hampden-Turner, have also issued a riposte to the idea that CDS — naked or otherwise — should be banned to alleviate pressure on certain sovereigns.

One of their arguments: wider CDS doesn’t push actual bond spreads wider. In other words, higher CDS doesn’t make it more expensive for governments to borrow or service their debt.

First a quick recap.

There are generally two types of CDS/bond arbitrage opportunities: positive or negative basis trades — basis being the difference between the CDS and bond spreads.

Positive basis trades take place when CDS is trading wider than bond spreads. You sell the bond and sell protection and wait for the basis to narrow.

In a negative basis trade, you would buy the bond and protection. CDS would be trading wider than the bond, so you simply cash in on the difference. And it doesn’t matter if the bond defaults since you’ll get the CDS pay-out.

Negative bases don’t happen very often — they tend to be arbitraged out quite quickly — but negative basis trades are popular as they carry “risk-free” implications. Hedgies generally love ‘em.

Here’s what the Citi analysts say:

The suggestion that sovereign CDS push spreads wider and limit governments’ ability to borrow money is compromised by low volumes relative to bonds. More striking still, the asymmetry of the no-arbitrage relationship between CDS and bonds means that while it is quite easy for CDS to drive bonds tighter, it is much harder for CDS to ‘force’ bonds wider in the way that is often alleged.

This mechanism is quite well understood in corporate space. CDS can drag bonds tighter insofar as if CDS trade tighter than bonds, investors can ‘buy the basis’ (buy the bond and buy protection on the bond) and lock in a profit. Were there to be a default, investors could just deliver the bond into the contract. Buying by such investors – provided financing is available – may well drag bond spreads down in absolute terms.

Positive bases, on the other hand, are much harder to arbitrage. When CDS trades wide to bonds, the arbitrage would require shorting a bond in order to sell protection. This is much harder to do: bonds typically ‘go special’ on repo and become hard to borrow. That means that positive bases are the norm rather than the exception, but that their magnitude has relatively little effect on bond levels. If anything, positive bases may increase demand from bond investors to buy new issues as they struggle to cover short positions in the existing issues.

For Greece the basis between five-year government bonds and five-year sovereign CDS is close to zero:

Back to Citi:

Frankly, we are surprised that the current basis on Greece is so close to zero; again, rather than suggesting that “speculators” have been pushing bonds wider, it is almost suggestive of the opposite. Investors who think Greek creditworthiness concerns will increase still further can today buy bonds and buy protection against them at close to zero spread. The tendency of CDS to move more than bonds means that on any widening, the investor would probably make money. The fact that the basis has recently reduced suggests that investors have been taking off short (risk) positions via CDS – perhaps for fear of a sudden ban. That said, the basis on the likes of Spain and Germany is still significantly positive.

The suggestion then is that far from relieving pressure on government bonds, banning CDS would just lead to more bond-selling.

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