Good afternoon

Let’s start off by discussing briefly here the concept of CDS basis, which is sometimes used to identify relative value opportunities or simply seek to explain market developments. Simply speaking, exposure to an issuer can be built by purchasing a bond or else by entering a derivative contract for which payoffs depend on whether a given issuer defaults or not. The most common derivative used in this vein is the Credit Default Swap, which is basically a form of insurance against a credit event; that is, through such a contract, one can seek protection from the default of a given issuer by paying an upfront premium (i.e. CDS premium). Hence, selling for example Fiat CDS or buying Fiat bonds expose one to similar risks, as in both cases a loss will occur if the issuer defaults. For this reason, the CDS premium should be in line with the bond spreads observed, considering of course similar maturities. The difference between the two is known as the CDS basis and is usually calculated by subtracting the bond spread from the premium. In the high yield market, the basis is most of the times negative reflecting the lower liquidity and the higher transaction costs that characterize the `cash` market (i.e. bonds).

Let’s now put this knowledge to practice. Although this exercise is not without shortcomings, we look for example at the Markit iBoxx EUR Liquid High Yield Index (and contrast it with the iTraxx Crossover 5 Year Total Return Index (a high yield CDS index). The two indices have consistently traded with a gap, reflecting differences in members and the general prevalence of a negative CDS basis in the high yield space. However, over the summer the gap widened significantly.

What does this mean? We see two possible explanations:

– Bonds underperformed because volatility increased not necessarily in response to greater credit risk worries but more following technical factors such as fund outflows;

– Investors reduced exposure to names excluded from the CDS index which are either smaller issuers or challenged by lower liquidity; if this is true, we would infer that investors are becoming more selective and worry about the declining liquidity of the bond markets as the markets have to adapt to a world were dealer inventories have declined substantially given regulatory changes.

Overall, we find the emergence of this gap as a possible positive for the high yield market as a whole even if some issuers might continue to lag.

Have a nice day!