The resilience of credit-default swap spreads to recent equity volatility has given rise to an unusual situation: a divergence between bond asset-swap spreads and the cost of equivalent credit protection. Credit derivative traders say this is opening the door to profit-taking using negative basis trades--a relative-value strategy in which players pocket the difference between the floating-rate spreads on the bond and the cost of the CDS.
Typically, cash and synthetic spreads move pretty much in line, but recent high issuance of collateralized debt obligations has put tightening pressure on synthetic spreads, said Matt King, head of quantitative credit strategy at Citigroup in London. This is caused by dealers hedging their long protection exposure, which is leveraged, by selling protection in huge quantities using the indices.
There is currently a nominal spread difference of 20 basis points between spreads on the synthetic iTraxx index and the cash iBoxx equivalent. This irregularity, however, is only being seen in Europe, which another strategist speculated is due to greater issuance of pure synthetics in the region.
One trading official at a U.S. house in London said negative basis trades were the main bread winner in his portfolio in July, but declined to put a figure on the notional invested or returns.
Credit pundits said it is unclear how long this cash/synthetic divergence will continue, but in the past any small negative basis moves have been short lived. "We expect the synthetic bid to remain strong, and think that this will continue to support CDS and hence keep the average basis under pressure," said King.
