Spanish Bond/CDS Basis Turns More Positive, Potential Trading Opportunity

The Bond/CDS basis is a way to measure the potential arbitrage opportunity in Credit Default Swaps and the underlying bonds. When bonds sell off, prices fall and yields rise. The increase in yields usually reflects an increase in the probability of default in the underlying bonds, as the increased bankruptcy risk requires a higher return via the yield.

Credit Default Swaps are priced in basis points, as investors are forced to pay a percentage of the bond's income as insurance to protect the bond's principle. The number of basis points paid is similar to the bond's yield, in that it takes into account the default risk of the bond.

As these securities track the same issuer for the same maturity, they have similar risk profiles. Financial theory says that any two assets of this nature must trade with no-arbitrage, meaning that the implied default risk should be the same. However, this is not always the case. The Bond/CDS basis tracks the divergence in these two assets, and allows traders to find arbitrage opportunities in fixed income markets.

A negative basis implies that the bond is pricing in a higher default probability than the CDS, and vice versa. Currently, Spanish bonds are trading with a rare positive basis, an interesting turn of events. The one-month Spanish bill is trading with a positive basis of 127.6 basis points, the highest in the last 30 days.

Traders can take advantage of this positive basis by buying the CDS on the 1-month Spanish bills and shorting the underlying bills. By doing so, traders are betting that the basis will narrow back towards parity and no-arbitrage equilibrium.

Do note that derivative trading carries large risks and only experienced traders should consider it.