A Markov Switching Cointegration Analysis of the CDS-Bond Basis Puzzle

We investigate the long-run equilibrium relationship between credit default swap (CDS) premia and bond spreads for 65 U.S. corporate entities and 6 major banks over the period April 2011 – February 2018. Standard regression methods reveal that in 40 out of 71 entities, the two series fail to be cointegrated, which is puzzling because it represents a violation of the efficient market hypothesis. Differently from the previous literature, we estimate a Markov switching vector error correction model to capture the fact that regimes may be characterize the adjustment mechanism and the short-term dynamics between the spread series. We use this framework to investigate how the two markets contribute to the price discovery of credit risk. We find that there are many entities that switch between a regime where the adjustment to the long-run cointegrating relationship does not take place and a regime where one between the CDS or the bond markets leads the price discovery. Finally, we investigate whether the industry or other firm characteristics, such as the rating, the leverage, and the capital structure, may be relevant to determine which of the two markets is leads in the price discovery process.