CDS-Bond Basis and Bond Return Predictability

69 Pages Posted: 22 Jan 2014 Last revised: 26 Dec 2019

See all articles by Gi H. Kim

Gi H. Kim

Warwick Business School - University of Warwick

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Weina Zhang

Department of Finance, National University of Singapore; National University of Singapore Risk Management Institute

Date Written: July 31, 2016

Abstract

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

Kim, Gi Hyun and Li, Haitao and Zhang, Weina, CDS-Bond Basis and Bond Return Predictability (July 31, 2016). Journal of Empirical Finance, Vol. 38, 307-337, September 2016, Available at SSRN: https://ssrn.com/abstract=2382489 or http://dx.doi.org/10.2139/ssrn.2382489

Gi Hyun Kim

Warwick Business School - University of Warwick ( email )

Coventry CV4 7AL
United Kingdom
+44 (0)24 7652 3849 (Phone)

Haitao Li

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Weina Zhang (Contact Author)

Department of Finance, National University of Singapore ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore
65168120 (Phone)
67792083 (Fax)

HOME PAGE: http://bizfaculty.nus.edu/faculty-profiles/108-weina

National University of Singapore Risk Management Institute ( email )

21 Heng Mui Keng Terrace
Level 4
Singapore, 119613
Singapore

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