The CDS-Bond Basis and the Cross Section of Corporate Bond Returns

Abstract

The CDS/Bond basis trade has played an important role in the current financial crisis. Many banks and hedge funds, such as Deutsche Bank, Merrill Lynch, and Citadel, have lost billions of dollars in this trade. The widening of the basis has also created significant disruptions in the credit market. In this paper, we provide a comprehensive empirical analysis on the CDS/bond basis and the impact of the basis on expected corporate bond returns. We construct the basis based on CDS spreads from Markit and bond prices from TRACE and NAIC from 2001 to 2008. We find that on average the basis of investment grade bonds is negative during our entire sample and that bonds with lower basis tend to be older and have lower rating, longer maturity, higher duration and convexity. We also find that low basis bonds tend to have higher future returns than high basis bonds and that the basis can predict future returns of individual bonds and bond portfolios. Most important, we find that the basis factor, constructed as the return differential between low and high basis portfolios, helps explaining the cross-sectional differences in the expected returns of corporate bonds even after controlling for most known systematic risk factors.