Basis trade opportunities created by volatile credit market

The upswing in credit market volatility in the past three months has led to an increased dislocation between cash bonds and credit default swaps, with investors profiting from basis trading opportunities.

“[It] has been a rollercoaster ride for credit spreads, and default swaps volatility has rocked the market,” said Merrill Lynch in a newly published research report. “For many credits this has meant that the basis has widened significantly.”Basis describes the difference between the derivative premium, in this case the credit default swap, and the underlying asset, in this case the asset swap spread. Negative basis occurs when the credit default swap trades lower than the underlying credit, offering opportunities for an investor to buy a bond and relatively cheap matched protection.

By contrast, positive basis trades offer investors the opportunity to sell protection as the default swap premium is priced higher relative to the underlying.

The greater volatility has prompted banks and creditors to increase their protection on weaker credits through credit default swaps. This, in turn, has pushed out credit default swap premiums, so increasing the positive basis on weaker credits.

“When you’re thinking of taking a negative view on a credit it is easier to go short by buying protection. So as the market moves further negative, the default levels widen relative to cash," said Atish Kakodkar, a vice-president in Merrill Lynch’s credit derivatives research department.

This has prompted a significant rise in the number of positive basis trades in the credit markets, said a London-based trader. He added that there were still opportunities for negative basis trades, but they were “a lot harder to spot”.Protection buyers have also been able to exploit structural factors surrounding credit derivatives – the protection buyer has the cheapest to deliver option which means that the seller is more likely to demand an increased premium for the greater risk incurred – this again pushes up the basis.

A third factor affecting the basis for lower-rated credits is the reduced number being included in synthetic collateralised debt obligations (CDOs) and first-to-default baskets. Synthetic CDOs involve protection being sold on a credit, which in turn would normally push the credit default swap premium tighter. Without the synthetic CDO activity there is less of an offset to the basis widening caused by the other two factors.

Merrill identified a number of credits, including Pilkington, BAT International Finance and Imperial Tobacco, as offering good basis trading opportunities.