It always seems like there is a trade du jour that certain market conditions, new products, or security liquidity issues can make particularly profitable. The negativ🔴e basis trade has represented such a trade for single corporate issuers. In this article, we explain why these opportunities exist and outline a basic way to execute a negative basis trade.

What Is Basis?

Basis has traditionally meant the difference between the spot (cash) price of a commodity and its future's price (derivative). This concept can be applied to the 澳洲幸运5官方开奖结果体彩网:credit derivatives market where basis represents the difference in spread between 澳洲幸运5官方开奖结果体彩网:credit default swaps (CDS) and bonds for the same debt issuer and with similar, if not exactly equal, 澳洲幸运5官方开奖结果体彩网:maturities. In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller th𒊎an the bond spread.

When a 澳洲幸运5官方开奖结果体彩网:fixed-income trader or portfolio manager refers to spread, this represents the difference between the bid and ask price over the treasury yield curve (treasuries are generally considered a 澳洲幸运5官方开奖结果体彩网:riskless asset). For the bond portion of the CDS basis equation, this refers to a bond's nominal spread over similar-term treasuries, or possibly the Z-spread. ൲Because int♛erest rates and bond prices are inversely related, a larger spread means the security is cheaper.

Fixed-income participants refer to the CDS portion of a negative basis trade as 澳洲幸运5官方开奖结果体彩网:synthetic (because a CDS is a derivꦚativ🌜e) and the bond portion as cash. So you might hear a fixed-income trader mention the difference in spread between synthetic and cash bonds when they are talking about negative basis opportunities.

Executing a Negative Basis Trade

To capitalize on the difference in spreads between the cash market and the 澳洲幸运5官方开奖结果体彩网:derivative market, the investor should buy the "cheap" asset and sell the "expensive" asset, consistent with the adage "buy low, sell high." If a ne♔gative basis exists, it means that the cash bond is the cheap asset and the credit defaul🍸t swap is the expensive asset (remember from above that the cheap asset has a greater spread). You can think of this as an equation:

$\text{CDS basis} = \text{CDS spread} - \text{bond spread}$CDS basis=CDS spread−bond spread

It is assumed that at or near bond maturity, the negative basis will eventually narrow (heading toward the natural value of zero). As the basis narrows, the negative basis trade will become more profitable. The investor can buy back the expensive asset at a lower price and sell the cheap asset at a 𒈔higher price, locking in a profit.

The trade is usually done with bonds that are trading at par or at a discount, and a single-name CDS (as opposed to an index CDS) of a tenor equal to the maturity of the bond (the tenor of a CDS is akin to maturity). The cash bond is purchased, while simultaneously🅷 the synthetic (single-name CDS) is shorted.

When you short a credit default swap, this means you have bought protection much like an insurance premium. While this might seem counterintuitive, remember that buying protection means you have the right to sell the bond at par value to the seller of the protection in the event of default or another negative 澳洲幸运5官方开奖结果体彩网:credit event. So, buying protection is equal to a short.

While the basic structure of the negative basis trade is fairly simple, complications arise when trying to identify the most viable trade opportunity and when monitoring that trade for the best opportunity to 澳洲幸运5官方开奖结果体彩网:take profits.

Market Conditions Create Opportunities

There are technical (market-driven) and fundamental conditions that create negative basis opportunities. Negative basis trades are usually done based on 澳洲幸运5官方开奖结果体彩网:technical reasons as it is assumed that the relationship is t⛎emporary and will eventually revert to a ꦗbasis of zero.

Many people use the synthetic products as part of their hedging strategies, which can cause valuation disparities versus the underlying cash market, especially during times of market stress. At these times, traders prefer the synthetic market because it is more liquid than the cash market. Holders of cash bonds may be unwilling or unable to sell the bonds they hold as part of their longer-term investment strategies. Therefore, they might look to the CDS market to buy protection on a specific company or issuer rather than simply sell their bonds. Magnify this effect during a crunch in the 澳洲幸运5官方开奖结果体彩网:credit markets, and you can se🔯e why these opportunities exist during ma🦂rket dislocations.

Nothing Lasts Forever

Since market dislocations or "澳洲幸运5官方开奖结果体彩网:credit crunches" create the conditions for a negative basis trade to be possible, it is very important for the holders of this trade to monitor the marketplace constantly. The negative basis trade will not last forever. Once market conditions revert back to historical norms, spreads also go back to normal, and liquidity returns to the cash market, the negative basis trade will no longer be attractive. But as history has taught us, another trading opportunity is always around the corner. Markets quickly correct inefficiencies𓂃, or create new ones.