The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns

Abstract

We provide a comprehensive empirical analysis on the implication of CDS-Bond basis arbitrage for the pricing of corporate bonds. Basis arbitrageurs introduce new risks such as funding liquidity and counterparty risk into the corporate bond market, which was dominated by passive investors before the existence of CDS. We show that a basis factor, constructed as the return differential between LOW and HIGH quintile basis portfolios, is a superior empirical proxy that captures the new risks. In the cross section of investment grade bond returns, the basis factor carries an annual risk premium of about 3% in normal periods.

Keywords: Credit Default Swap, CDS-Bond Basis Arbitrage, Corporate Bond Returns, Basis Risk Factor, Financial Crisis, Funding Liquidity, Counterparty Risk, Limits-to-Arbitrage

JEL Classification: G10, G12