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Trends in credit basis spreads

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Abstract

Market participants and policymakers were surprised by the large, prolonged dislocations in credit market basis trades during the second half of 2015 and the first quarter of 2016. In this article, we examine three explanations proposed by market participants: increased idiosyncratic risks, strategic positioning by asset managers, and regulatory changes. We find some evidence of increased idiosyncratic risk during the relevant period, but limited evidence of asset managers changing their positioning in derivative products. Although we cannot quantify the contribution of these two channels to the overall level of spreads, the relative changes in idiosyncratic risk levels and in asset manager derivative positions appear small compared with the observed spreads. We present the mechanics of the CDS-bond arbitrage trade, tracing its impact on a stylized dealer balance sheet and the return on equity (ROE) calculation. We find that, given current levels of regulatory leverage, the CDS-bond basis needs to be significantly more negative than pre-crisis levels to achieve the same ROE target.

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  • Nina Boyarchenko & Pooja Gupta & Nick Steele & Jacqueline Yen, 2018. "Trends in credit basis spreads," Economic Policy Review, Federal Reserve Bank of New York, issue 24-2, pages 15-37.
    • Handle: RePEc:fip:fednep:00048
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    References listed on IDEAS

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    1. Trapp, Monika, 2009. "Trading the bond-CDS basis: The role of credit risk and liquidity," CFR Working Papers 09-16, University of Cologne, Centre for Financial Research (CFR).
    2. Tobias Adrian & Nina Boyarchenko, 2012. "Intermediary leverage cycles and financial stability," Staff Reports 567, Federal Reserve Bank of New York.
    3. repec:bla:jfinan:v:58:y:2003:i:3:p:975-1008 is not listed on IDEAS
    4. Jaewon Choi & Or Shachar, 2013. "Did liquidity providers become liquidity seekers?," Staff Reports 650, Federal Reserve Bank of New York.
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    Cited by:

    1. Boyarchenko, Nina & Crump, Richard K. & Kovner, Anna & Shachar, Or, 2025. "Corporate bond market distress," Journal of Monetary Economics, Elsevier, vol. 152(C).
    2. Nina Boyarchenko & Anna M. Costello & Or Shachar, 2018. "Credit Market Choice," Liberty Street Economics 20181017, Federal Reserve Bank of New York.
    3. Doshi, Hitesh & Ericsson, Jan & Fournier, Mathieu & Seo, Sang Byung, 2024. "The risk and return of equity and credit index options," Journal of Financial Economics, Elsevier, vol. 161(C).

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    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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