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The Autumn 2009 Bank of Canada Review contained an article by Alejandro Garcia and Jun Yang titled Understanding Corporate Bond Spreads Using Credit Default Swaps that, frankly, has me rather puzzled.

They state:

We use credit default swaps to decompose the spreads on Canadian corporate bonds because, as discussed in the next section, their lower susceptibility to liquidity effects makes them a much purer measure of default risk.
…
CDS contracts are commonly used to extract proxies for default risk for several reasons. As contracts, not securities, CDSs are far less sensitive to liquidity effects, since securities are in fi xed supply, while the supply of CDSs can be arbitrarily large. Because of this reduced sensitivity, CDSs provide a better measure of default risk. As well, it is less costly for investors to liquidate CDSs prior to maturity than to liquidate a corporate bond, since investors simply enter into a swap contract in the opposite direction. Further, CDSs are not likely to become “special” like treasury bills, or “squeezed” like corporate bonds. In principle, therefore, CDSs should contain mainly default information about the reference entity. However, they are not totally immune to liquidity effects, since search costs may be high for illiquid CDS contracts.
…
In this model, investors demand a return for holding corporate bonds that includes the risk-free rate, the default risk of the issuer, and the liquidity premium associated with the security. Similarly, investors demand compensation for selling the CDS that includes the risk-free rate and the default risk associated with the reference entity (bond issuer). Note that, in the model, we assume that the bond yield includes compensation for liquidity and default risk, whereas the CDS includes compensation only for default risk.

They derive the following decomposition. It should be noted that their phrase “average investment grade firm” is a little general, since they only had data for six companies, all BBB:

My problem is that I don’t understand their methodology. It ignores arbitrage – which means that you cannot capture the liquidity component by buying the bond and buying protection – and it would appear to blow up when confronted with the problem of positive basis trades, which (as observed by Choudhry) are are most common; negative basis trades became more common during the Crunch due to funding risk. For example:

BMO Capital Markets: Negative Basis Trades:

We recently executed a number of negative basis trades for clients involving auto companies when bond spreads were trading significantly wider than the CDS cost of protection. Investors were typically able to earn net spreads in excess of 25 bps after hedging both their interest rate risk and credit risk. This net spread offered a very attractive return for the risk resulting from this combination of transactions, i.e. a better than senior bank debt spread for assuming credit risk exposure that is meaningfully lower than direct bank exposure since the investor only looks to the bank CDS counterparty if the bond issuer fails.

Negative basis opportunities arise from time to time, but tend not to last for very long – investors who are able to act quickly are the big beneficiaries. We are active in the market, highlighting negative basis trade ideas for interested investors.

I have sent a query to the authors and will update this post if I get an answer.

Update: The methodology’s seminal paper by Longstaff (better link) examines CDS & bond yield spreads for Enron, which occasionally went negative, particularly towards the end. He notes:

It is important to acknowledge that our empirical approach of using a bracketing set of bonds does not eliminate all measurement error. This may partially explain why some of the percentages shown in Figure 3 for the size of the default component (particularly for the cases in which the Treasury and Refcorp curves are used) are in excess of 100.

It strikes me that dismissing negative basis as measurement error is cheating.

Doubt has been cast on the methodology by the results of Mahanti, Nashikkary & Subrahmanyam

Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their risk-less benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds, as measured by their ease of market access, to the basis between the credit default swap (CDS) price of the issuer and the par-equivalent corporate bond yield spread. The ease of access of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk negatively affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond. In a similar vein, we document that bond-level variables related to features of the contract that may be related to credit risk, such as the presence of covenants, have a negative impact on the CDS-bond basis. These findings are consistent with the presence of frictions in the arbitrage mechanism between the CDS and bond markets, due to the costs of shorting” bonds.

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