Absolute negative basis: Meaning, Criticisms & Real-World Uses

What Is Absolute Negative Basis?

Absolute negative basis, within the realm of credit derivatives, describes a market condition where the cost of purchasing credit protection through a credit default swap (CDS) is less than the implied credit risk derived from the underlying corporate bond's spread. This divergence creates a scenario where the synthetic exposure (via CDS) is "cheaper" than the cash market exposure (via the bond). It indicates a dislocation in financial markets between the pricing of credit risk in the cash bond market and the derivatives market.

This phenomenon is a specific aspect of basis trading, which falls under the broader category of derivatives and relative value strategies in portfolio management. When an absolute negative basis exists, it suggests that the market perceives the credit risk of an entity differently across its debt instruments.

History and Origin

The concept of basis, or the difference between the price of a cash instrument and its derivative, has long existed in commodity and futures markets. However, the application of "negative basis" in the context of credit derivatives gained prominence with the growth and increasing sophistication of the credit default swap market in the early 2000s. As CDS became more liquid and widely traded, discrepancies between the pricing of credit risk in the bond market and the CDS market began to appear more frequently. These dislocations often created opportunities for arbitrage strategies. The Securities and Exchange Commission (SEC) also introduced regulations such as Regulation SHO in 2005 to address practices like "naked short selling," which can influence market dynamics and potentially contribute to basis anomalies, although directly impacting equity markets, it indirectly highlights the need for robust regulation in derivatives trading⁶,.

Key Takeaways

Absolute negative basis occurs when the spread on a credit default swap is less than the spread on its corresponding underlying corporate bond.
It signifies a pricing dislocation between the synthetic credit market and the cash bond market.
This condition often presents opportunities for relative value trading strategies, such as buying the cheaper bond and simultaneously buying CDS protection.
Factors like liquidity differences, funding costs, and regulatory considerations can contribute to the existence and persistence of an absolute negative basis.
While theoretically an arbitrage opportunity, practical execution can be complex due to transaction costs and market frictions.

Formula and Calculation

The absolute negative basis is calculated as the difference between the credit default swap spread and the corresponding corporate bond spread. Both spreads represent the market's assessment of credit risk for the same underlying entity, but they are derived from different financial instruments.

The formula for CDS basis is:

$\text{CDS Basis} = \text{CDS Spread} - \text{Bond Spread}$

Where:

CDS Spread is the annual premium (in basis points) that the protection buyer pays to the protection seller for the credit default swap.
Bond Spread is the yield spread of the corporate bond over a risk-free benchmark rate (e.g., U.S. Treasury yield) for a similar maturity.

A negative result indicates an absolute negative basis, meaning the CDS spread is lower than the bond spread.

Interpreting the Absolute Negative Basis

An absolute negative basis suggests that the market is valuing credit protection via the credit default swap more cheaply than the implied credit risk from holding the underlying fixed income bond. Traders and investors interpret this discrepancy as a potential mispricing. Typically, in an efficient market, these two measures of credit risk for the same entity should align closely.

When an absolute negative basis is observed, it implies that investors could theoretically "buy" credit exposure more economically in the synthetic market (by selling CDS protection) than in the cash market (by holding the bond). Conversely, for those looking to hedge credit risk, it means that protection is less expensive to acquire via CDS than the perceived risk from the bond's yield (finance) suggests. This situation can arise from factors such as differences in liquidity between the bond and CDS markets, technical trading flows, or varying supply and demand dynamics in each segment of the capital markets.

Hypothetical Example

Consider XYZ Corp., which has a corporate bond trading in the market with a spread of 250 basis points above the risk-free rate. Simultaneously, a credit default swap on XYZ Corp. with a similar maturity is trading at a spread of 230 basis points.

Using the formula for CDS basis:
$\text{CDS Basis} = \text{CDS Spread} - \text{Bond Spread}$
$\text{CDS Basis} = 230 \text{ bps} - 250 \text{ bps}$
$\text{CDS Basis} = -20 \text{ bps}$

In this scenario, an absolute negative basis of -20 basis points exists. This indicates that buying credit protection on XYZ Corp. via a CDS is 20 basis points cheaper than the implied credit risk from owning the bond directly. A trader might attempt to profit from this by executing a "negative basis trade," which typically involves buying the XYZ Corp. bond (the "cheap" asset) and simultaneously buying protection (selling the CDS) on XYZ Corp. (the "expensive" asset from a spread perspective). The expectation is that this basis will eventually converge to zero or become less negative, allowing the trader to unwind the position for a profit.

Practical Applications

Absolute negative basis primarily appears in the realm of sophisticated fixed income trading and hedging strategies.

Arbitrage Opportunities: Professional traders often seek to exploit the absolute negative basis through a type of arbitrage known as a "negative basis trade." This strategy involves buying the underlying corporate bond and simultaneously buying credit protection through a credit default swap on the same entity. The goal is to profit from the expected convergence of the CDS spread and the bond spread.⁵
Relative Value Analysis: For investors, the presence of an absolute negative basis can signal a relative value opportunity, indicating which form of credit exposure might be more attractive at a given moment. It prompts a deeper analysis into why the dislocation exists.
Market Indicator: A persistent absolute negative basis can sometimes indicate specific market dynamics, such as high demand for short selling in the CDS market or structural inefficiencies. For example, higher central bank rates making bond purchases more expensive can lead to sold CDS being preferred for long bond positions, driving down CDS spreads and potentially creating a negative basis.⁴
Regulatory Scrutiny: While not directly tied to taxation, financial regulators, such as the SEC, monitor derivative markets and trading practices (e.g., through rules like Regulation SHO) to ensure market integrity and prevent manipulative activities that could influence pricing discrepancies like an absolute negative basis.³

Limitations and Criticisms

While an absolute negative basis may present theoretical arbitrage opportunities, several practical limitations and criticisms exist.

Transaction Costs: Executing negative basis trades involves multiple transactions (buying a bond, buying CDS protection), each incurring fees and commissions that can erode potential profits, especially if the basis is only slightly negative.
Funding Costs: The cost of funding the long bond position can significantly impact the profitability of a negative basis trade. Higher interest rates or increased funding costs can make these trades less attractive.²
Liquidity Mismatch: While both bonds and CDS are generally liquid, there can be differences in liquidity between the two markets for a specific issuer or tenor, making it challenging to execute large positions without impacting prices.
Basis Persistence: There is no guarantee that an absolute negative basis will converge to zero or become less negative within a desirable timeframe. Market dislocations can persist longer than anticipated due to various factors, including technical pressures, supply-demand imbalances, or unique market events.
Credit Events: The strategy assumes no credit event will occur. If a credit event does happen, the trade's mechanics change, and the profitability depends on how the bond and CDS settle.
Regulatory Changes: Evolving regulations in the derivatives and short-selling markets (e.g., SEC Regulation SHO) can influence trading behavior and potentially impact basis relationships.

Absolute Negative Basis vs. Positive Basis

The distinction between absolute negative basis and positive basis lies in the relationship between the credit default swap (CDS) spread and the underlying corporate bond spread.

An absolute negative basis occurs when the CDS spread is less than the bond spread. This implies that credit protection is cheaper in the synthetic market than what the cash bond's implied risk suggests. Such a scenario might prompt a "buy bond, buy CDS protection" strategy, betting on the basis narrowing.

Conversely, a positive basis arises when the CDS spread is greater than the bond spread. In this case, credit protection in the synthetic market is more expensive than the implied risk from the cash bond. A positive basis trade would typically involve selling the bond (or short selling it) and simultaneously selling CDS protection (i.e., taking on credit risk via the CDS) to profit from the expected convergence.

The confusion between these two terms is minimal once their definitions are understood as they represent opposite market conditions. The key is to remember that basis is always calculated as the derivative spread minus the cash spread, and the sign of the result dictates whether it's positive or negative.

FAQs

What does "basis" mean in finance?

"Basis" in finance generally refers to the difference between the price of a cash instrument (like a corporate bond) and its corresponding derivative (like a credit default swap or futures contract). It can also refer to the cost basis of an asset for tax implications purposes, as outlined by the IRS in publications like IRS Publication 551¹.

How does absolute negative basis relate to risk?

An absolute negative basis itself is not a direct measure of risk but an indicator of a pricing anomaly. It suggests that the market may be underpricing credit risk in the credit default swap market relative to the bond market. For a trader trying to profit from this, the primary risk lies in the basis not converging as expected, or the trade's profitability being eroded by transaction costs or funding expenses.

Is an absolute negative basis always an opportunity for profit?

While an absolute negative basis theoretically presents an arbitrage opportunity, it is not always guaranteed to be profitable in practice. Factors such as liquidity constraints, funding costs, transaction fees, and the risk that the basis might not converge or could even widen further, can limit or eliminate potential profits.

Can individuals trade on absolute negative basis?

Trading strategies involving absolute negative basis are typically complex and primarily employed by institutional investors, hedge funds, and sophisticated desks at investment banks. This is due to the high capital requirements, specialized knowledge of credit derivatives, access to institutional trading platforms, and the ability to manage the associated risks.