Back to Basis Limits to Arbitrage and CDS–Bond Basis Deviations in the European Investment Grade Bond Market during the Covid-19 Crisis

Abstract

This thesis examines what drives differences between credit default swap (CDS) spreads and corporate bond credit spreads, known as the CDS–bond basis, in the European investment grade market during 2020, with a focus on the Covid-19 crisis. A corporate bond credit spread is the extra return investors require to hold a risky bond instead of a safe government bond. A CDS spread is the insurance premium paid to protect against default on the same firm. Both measures reflect the same underlying credit risk, which is the risk that the firm fails to repay its debt. In a frictionless market, CDS spreads and credit spreads should be closely aligned when they refer to the same firm and maturity. An investor can either hold the bond and bear the default risk, or hedge that risk by buying CDS protection. Since both positions are linked to the same default event, the cost of bearing or hedging that risk should be similar, implying a CDS–bond basis close to zero. However, large and persistent deviations are often observed, especially during periods of market stress, indicating that market frictions may affect pricing. This thesis examines whether such frictions can explain the CDS–bond basis during the Covid-19 crisis. Using daily panel data for 36 firms included in the iTraxx Europe index, our analysis constructs a synthetic five year credit spread by interpolating between available bond yields for each firm and estimates the CDS–bond basis using firm fixed effects panel regressions. The iTraxx Europe index tracks liquid CDS contracts on major European investment grade firms. Investment grade refers to firms with relatively high credit quality and low default risk, while firms below this threshold are typically classified as speculative grade or high yield. Our analysis focuses on four main drivers of CDS-bond basis deviations. Bond market illiquidity reflects how difficult it is to trade bonds. Counterparty risk captures the likelihood that the CDS seller fails to honor the contract. Market wide uncertainty is measured using implied volatility, which reflects how uncertain investors are about future market conditions. Funding conditions reflect how costly it is to finance arbitrage positions. Our results show that bond market illiquidity is strongly associated with a more negative basis, suggesting that higher trading costs limit arbitrage activity. Market wide uncertainty and tighter funding conditions display similar negative effects. Counterparty risk shows a positive relationship with the CDS–bond basis, which differs from the negative relationship predicted in Bai and Collin-Dufresne (2019) and Augustin and Schnitzler (2021). Our positive relationship between counterparty risk and the CDS–bond basis is likely explained by post crisis regulatory changes and limitations in the empirical proxy. Our findings indicate that the large negative CDS–bond basis observed during the Covid-19 crisis was primarily driven by market wide conditions that constrained arbitrage, rather than by changes in underlying credit risk. Overall, our results indicate that limits to arbitrage play a central role in explaining CDS–bond basis deviations in the European market.