Credit Default Swaps and the CDS-Bond Basis (Chapter 19, Part 2)

Book: Fixed Income Securities: Tools for Today’s Markets | Author: Bruce Tuckman & Angel Serrat | ISBN: 978-0-470-89169-8

Previous: Corporate Bonds, Ratings, and Credit Spreads (Chapter 19, Part 1) | Next: Mortgages and Mortgage-Backed Securities (Chapter 20)

Part 2 of Chapter 19 is CDS: how protection is bought and sold, how quotes map to up-front fees, and why bonds and CDS rarely line up even when they should.

CDS Mechanics

A CDS is insurance on a reference entity. The protection buyer pays a quarterly fee. The seller pays compensation if a credit event hits before maturity. Events include bankruptcy, failure to pay, restructuring, and more.

Settlement matters. Physical settlement: deliver eligible bonds, receive par. Works like futures delivery lists. Cheapest-to-deliver affects pricing. Cash settlement: an auction sets recovery R, then the seller pays (1 - R) per face. Lehman secured debt auctioned near 9 in Oct 2008. WaMu senior near 57.

Post-crisis standardization changed the market. Maturities cluster on IMM dates (20th of Mar/Jun/Sep/Dec). Coupons fix at 100 or 500 bp with an up-front payment to balance fair value. Unwinding is easy: buy protection back at the new up-front and you are flat.

HOV (Hovnanian) in Nov 2008: 55.5 up-front plus 500 bp annual on five-year protection. Distressed names quote up-front. IG names quote spread, then derive up-front.

Quoting: Fee Leg vs Contingent Leg

Market convention splits CDS value into two legs. The fee leg is expected discounted coupons (plus accrued on default, assumed mid-period). The contingent leg is expected discounted (1 - R) on default. Fair pricing finds hazard rate h* such that fee leg equals contingent leg, usually with R = 40%.

The quoted spread s_Q is the running coupon with zero up-front. The standardized coupon s_S is 100 or 500 bp. The up-front U makes the seller indifferent between s_S and s_Q:

U = PV(s_S - s_Q)

Deutsche Bank five-year EUR CDS on Mar 21, 2011: quoted 95.33 bp vs 100 bp standardized coupon. Hazard rate 1.61%. Each leg worth 4.55% of face. Buyer receives about EUR 22,272 up-front on EUR 10mm notional because the market spread is below the standardized coupon.

Bloomberg CDSW does this. Your own fair value model can differ entirely. The math here is quoting convention, not gospel.

CDS-Bond Basis

Want credit exposure? Buy bonds or sell CDS protection. The CDS-bond basis asks which is cheaper.

Method 1: Implied hazard from bond price, then solve for CDS-equivalent spread s_B. Deutsche Bank floater at 100.83 in Mar 2011 implied 0.62% hazard vs 1.61% from CDS. CDS-equivalent spread 36.5 bp vs market 95.33 bp. Bond rich to CDS. Buy exposure via CDS, sell via bonds.

Method 2 (older): CDS spread minus par asset swap spread. Simple and popular pre-standardization. Not arbitrage. Appendix B walks through why: swap NPV at default, repo haircuts, capital costs, LIBOR-repo spread. You need a chain of heroic assumptions to get equality.

The real wedge is financing. CDS needs collateral calls, not bond repo. Bonds need capital or rolling repo for years. Lenders hate long-term repo in stress. Shorts are hard to borrow. Negative basis (bonds cheap to CDS) blew out to -250 bp for IG in 2007-2009 when funding died. Delivery option on CDS also inflates quoted spreads.

KB Home Negative Basis Trade

Nov 10, 2008: KB Home 5.75s at 68.66. Par asset swap spread 9.23%. CDS at 664 bp, zero up-front. Gap: 259 bp.

Trade: buy bond, buy CDS protection. If bond defaults, recovery R on bond plus (1-R) from CDS nets 100. Interim cash flows depend on repo (50% haircut at 2%), capital cost K, and CDS premium.

Worst case: no default, fund negative carry to maturity. Breakeven capital cost about 9.6%. Below that, the trade wins if you can hold through.

The catch is the word “if.” Repo rolls. Marks move. Rates shift. The trade that looked like free carry was a bet on stable financing, not just credit relative value.

Credit-Adjusted DV01

Yield DV01 assumes all coupons pay. Distressed bonds may pay partial principal early via default. Hazard-rate pricing fixes this.

Bond value = PV(coupons | survival) + PV(recovery | default). Shift the benchmark curve, reprice, compute DV01.

Example: 10-year 6% bond at 57.62 (14% yield). Yield DV01 0.0365, duration 6.34. Hazard rate 23% at 40% recovery. Credit-adjusted DV01 0.0228, duration 3.95. Default shortens effective life. Rate risk drops.

Index CDS

iTraxx (Europe) and CDX (North America) bundle 125 names. Semiannual series on IMM dates. Five-year is most liquid. After a default, notional drops (name removed, no replacement).

Figure 19.6 shows 2007-2009 protection costs spiking, especially crossover (below-IG) indexes. Figure 19.7 shows inverted credit term structure: 10y minus 5y protection cost went negative after Sep 2008. Near-term default fear dominated.

Closing Thought

CDS and bonds express the same underlying risk through different balance sheets. Cash needs financing. Synthetic needs collateral and counterparty management. Spreads diverge when those frictions matter, which is exactly when you care most.

Chapter 20 shifts to mortgages: prepayment options, negative convexity, and the crisis product that broke the housing market.