Credit Default Swap Bond Research Articles

Arbitrage Costs and the Persistent Non-Zero CDS-Bond Basis: Evidence from Intraday Euro Area Sovereign Debt Markets

We find evidence that in the market for euro area sovereign credit risk, arbitrageurs engage in basis trades between credit default swap (CDS) and bond markets only when the CDS-bond basis exceeds a certain threshold. This threshold effect is likely to reflect costs that arbitrageurs face when implementing trading strategies, including transaction costs and costs associated with committing balance sheet space for such trades. Using a threshold vector error correction model, we endogenously estimate these unknown trading costs for basis trades in the market for euro area sovereign debt. During the euro sovereign credit crisis, we find very high transaction costs of around 190 basis points, compared to around 80 basis points before the crisis. Moreover, we find that once the threshold has been exceeded, the basis reverts back towards its long-run equilibrium substantially faster than when the basis is below the threshold. Our findings help explain the persistent non-zero basis or spread between credit risk premia in CDS and sovereign bond markets and suggest that the significant increase in the basis during the crisis was due to sharply higher costs facing arbitrageurs in the market, as well as compensation for increased risk that the trade would go against them in the short run.

The Interactions between the Credit Default Swap and the Bond Markets in Financial Turmoil

AbstractWe analyse the links between credit default swap (CDS) and bond spreads in order to determine which one is the leading market in the price discovery process. To do that, we construct a sample of CDS premia and bond spreads on a generic 5‐year bond for 17 financials and 18 sovereigns. First, we run panel vector error correction model estimations, showing that the CDS market has a lead over the bond market for financial institutions. This also holds for high‐yield sovereigns, whereas the reverse is found for low‐yield sovereigns in the core of the euro area. We interpret these results according to the relative liquidity of both markets for different types of entities. Second, we check for nonlinearities in the adjustment process. Results show that the CDS market's lead is amplified when default risk increases, during crisis periods, as well as continuously when CDS premia increase.

Did the CDS market push up risk premia for sovereign credit?

Summary We examine the empirical relationship between credit default swap (CDS) premia and government bond spreads for Portugal, Italy, Ireland, Greece, and Spain (the ‘PIIGS’ countries). We find some evidence for a long-run relationship in the sense of cointegration for the two markets. In most cases (five out of seven), only CDS premia contribute to the price discovery process. In the other cases, both markets make a more or less equal contribution. All in all, this suggests that bond spreads react only sluggishly to long-term imbalances, as measured by the cointegrating relationship. In light of this, we can conclude that, in most cases, CDS markets are leading markets if there is a long-run relationship between the CDS and government bond spread markets. This may partly be due to liquidity effects.

Liquidity Interactions in Credit Markets: An Analysis of the Eurozone Sovereign Debt Crisis

At the end of 2009, countries in the Eurozone began to experience a sudden divergence of bond yields as the perceived prospect of sovereign default risk increased. This paper examines the potential spillovers between the liquidity of the sovereign credit default swap (CDS) market and the liquidity of the sovereign bond market for a group of Eurozone countries. Empirically, we consider the differential spread on various Eurozone members sovereign bonds over the equivalent German benchmark. Using a unique dataset, constructed from the tick by tick transaction history from the 5-10 year maturity of the sovereign bond and CDS markets, we find that for countries such as Portugal, Spain and Ireland, the CDS market reveals a growing influence on bond yields post 2009. We provide substantial evidence that Greek sovereign CDS spreads and debt spreads do not exhibit the same time varying correlative patterns. Furthermore, we suggest that CDS spreads and bond credit spreads for Greek debt have correctly priced the default risk and that the trend patterns observed have not been substantially affected by changes in the liquidity profiles of either market. On a general note, we show that the bond yield liquidity spreads have increased substantially over the 2007-2010 period whilst CDS liquidity spreads have fallen dramatically. For some countries, such as Portugal, liquidity risk plays an important role in the sovereign bond market

Types of liquidity and limits to arbitrage—the case of credit default swaps

AbstractUsing a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period June 2008 to September 2009, we show that funding liquidity (shadow cost of capital for arbitrageurs) as well as asset‐specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage‐based parity relationship between the CDS prices and bond yield spreads (CDS‐Bond spread basis). Collectively, our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding‐period of 127 days, but the path to convergence is not smooth. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark

Liquidity Spillovers in Sovereign Bond and CDS Markets: An Analysis of The Eurozone Sovereign Debt Crisis

At the end of 2009, countries in the Eurozone began to experience a sudden divergence of bond yields as the perceived prospect of sovereign default risk increased. This paper examines the potential spillovers between the liquidity of the sovereign credit default swap (CDS) market and the liquidity of the sovereign bond market for a group of Eurozone countries. Empirically, we consider the differential spread on various Eurozone members sovereign bonds over the equivalent German benchmark. Using a unique dataset, constructed from the tick by tick transaction history from the 5-10 year maturity of the sovereign bond and CDS markets, we find that for countries such as Portugal, Spain and Ireland, the CDS market reveals a growing influence on bond yields post 2009. We provide substantial evidence that Greek sovereign CDS spreads and debt spreads do not exhibit the same time varying correlative patterns. Furthermore, we suggest that CDS spreads and bond credit spreads for Greek debt have correctly priced the default risk and that the trend patterns observed have not been substantially affected by changes in the liquidity profiles of either market. On a general note, we show that the bond yield liquidity spreads have increased substantially over the 2007-2010 period whilst CDS liquidity spreads have fallen dramatically. For some countries, such as Portugal, liquidity risk plays an important role in the sovereign bond market.

Types of Liquidity and Limits to Arbitrage - The Case of Credit Default Swaps

Using a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period 6/2008 to 9/2009, we show that funding-liquidity (shadow cost of capital for arbitrageurs) as well as asset specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage based parity relationship between the CDS prices and bond yield spreads (CDS-Bond spread basis). Collectively our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these two types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding period of 127 days, but the path to convergence is not smooth.

Non-Default Component of Sovereign Emerging Market Yield Spreads and Its Determinants:Evidence from the Credit Default Swap Market

This article shows that a sizable component of emerging market sovereign yield spreads is due to factors other than default risk, such as liquidity. The author estimates the non-default component of the yield spreads as the basis between the actual credit default swap (CDS) premium and the hypothetical CDS premium implied by emerging market bond yields. On average, the basis is large and positive for speculative-grade bonds and slightly negative for investment-grade bonds. The large positive basis for speculative-grade bonds supports the existence of speculation in the CDS market when the underlying9s credit quality is bad. The author studies the effects of bond liquidity, liquidity in the CDS market, equity market performance, and macroeconomic variables on the non-default component of the emerging market yield spreads. The results show that bond liquidity has a significant and positive effect on the CDS–bond basis of investment-grade bonds. The results suggest that the liquid bonds of investment-grade bonds are more expensive relative to the prices implied their CDS premiums. However, the results are somewhat mixed and even contrary for the speculative-grade bond sample. <b>TOPICS:</b>Emerging markets, credit default swaps, fixed-income portfolio management

The behavior of emerging market sovereigns' credit default swap premiums and bond yield spreads

AbstractWe test whether credit risk for Emerging Market Sovereigns is priced equally in the credit default swap (CDS) and bond markets. The parity relationship between CDS premiums and bond yield spreads (BYS), that was tested and largely confirmed in the literature, is mostly rejected. Prices below par can result in positive basis, i.e. CDS premiums that are greater than BYS and vice versa. To adjust for the non‐par price, we construct the BYS implied by the term structure of CDS premiums for various maturities. We are able to restore the parity relation and confirm the equivalence of credit risk pricing in the CDS and bond markets for many countries that have bonds with non‐par prices and time varying credit quality. We detect non‐parity even after the adjustment mainly in countries in Latin America, where the bases are larger than the bid–ask spreads in the market. We also find that the repo rates of bonds decrease around episodes of credit quality deterioration, which helps the basis remain positive. Copyright © 2009 John Wiley &amp; Sons, Ltd.

Liquidity Premia in the Credit Default Swap and Corporate Bond Markets

This paper employs a new approach to estimating the size of liquidity premia in the credit default swap (CDS) and corporate bond markets. We develop a CDS pricing model with liquidity and default, and a corporate bond pricing model with default, taxes, and liquidity using the reduced-form approach, and jointly estimate parameters of both pricing models from pooled data using the generalized method of moments. By formulating default intensity as a common factor of the spreads of the CDS and reference bonds, we are able to identify the liquidity and other components of spreads more precisely. We find that both CDS and corporate bond spreads contain significant liquidity components. On average, the liquidity premium accounts for 13% of the CDS spread and 23% of the corporate yield spread. The size of the liquidity premium increases as the rating decreases. Estimates of liquidity premia in the CDS and corporate bond markets are highly correlated, and closely linked to bond-specific and aggregate liquidity measures. Results show that liquidity is important for CDS and corporate bond pricing. Ignoring CDS illiquidity results in a significant bias in estimation of corporate yield spread components when using the CDS information to aid in decomposition of spreads.