CDS-Bond Basis and Bond Return Predictability
69 Pages Posted: 22 Jan 2014 Last revised: 26 Dec 2019
Date Written: July 31, 2016
We examine the predictive power of the CDS-bond basis for future corporate bond returns. We find that residual basis, the part of the CDS-bond basis that cannot be explained by a wide range of market frictions such as counterparty risk, funding risk, and liquidity risk, strongly negatively predicts excess returns. Controlling for systematic risk factors, including credit risk and liquidity risk, we find that a bond portfolio formed on the residual basis generates a significant abnormal bond return of 1.79% at the 20-day horizon. The abnormal returns due to the residual basis reflect mispricing rather than missing systematic risk factors. These results are robust to different horizons and sample periods and to the various characteristics of bonds. Overall, our results imply a beneficial role of CDS in the bond market as the existence of mispricing between CDS and bonds results in a subsequent price convergence in bonds.
Keywords: Credit default swaps, CDS-bond basis, basis arbitrage, corporate bonds, financial crisis, limits of arbitrage, price convergence
JEL Classification: G10, G12
Suggested Citation: Suggested Citation