CDS-Bond Basis and Differences Between Credit Spreads
Summary
The discussion compares a credit default swap premium with the spread between a corporate bond yield and a comparable risk-free yield. In a simplified theoretical setting, owning a bond while buying CDS protection on the issuer should remove default exposure and leave a risk-free return. This motivates comparing the annual CDS premium with the bond’s yield spread over the risk-free rate; their difference is called the CDS-bond basis.
The answer explains that the two measures can diverge in practice. A CDS introduces counterparty credit exposure in addition to the reference issuer’s credit risk, and the basis can also reflect market supply and demand, regulation, and trading frictions. It describes historical shifts in the basis and links changing bank capital rules to demand for CDS, but flags uncertainty around the cited historical trading share. The explanation is a conceptual overview, not a full pricing derivation; tenor, liquidity, and other instrument differences also affect comparisons.
Key ideas
- In theory, a bond combined with CDS protection can leave a risk-free return if default risk is fully hedged.
- The CDS-bond basis is the CDS premium minus the bond yield spread over a risk-free rate.
- CDS protection adds counterparty credit exposure that is absent from simply holding the bond.
- Supply, demand, regulatory treatment, and trading frictions can cause the basis to diverge from zero.
- Comparisons require attention to maturity, liquidity, and other differences between the instruments.
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Full text
# CDS Vs Credit Risk premium over risk free
# CDS Vs Credit Risk premium over risk free
Credit default swap is the premium you pay to protect against a credit default from your borrower.
Would it be equal to the credit premium over risk free i.e. bond yield - risk free of comparable maturity Treasury security (adjusted for tenor, liquidity etc)?
## Answer by Daneel Olivaw (score 2)
https://quant.stackexchange.com/a/35338
In theory, it should indeed be equal as holding a bond $B_t$ from some company $X$ as well as paying on a CDS written on the bond should earn you the risk-free rate, given the CDS hedges the default risk of your bond.
In practice, there is a CDS-bond basis, which is equal to:
$$ \text{Basis}_{\text{ CDS-Bond}} = \text{Premium}_{\text{ CDS}} - \text{Spread}_{\text{ Bond}} $$
Where $\text{Premium}_{\text{ CDS}}$ is the CDS annual premium and $\text{Spread}_{\text{ Bond}}$ the difference between the bond yield and the risk-free rate.
AFAIK historically these basis have been positive: indeed, in a CDS your credit exposure is higher than with a bond because you are not only exposed to the credit risk of $X$ but also to the credit risk of the counterparty with whom you have entered the CDS trade.
However, again AFAIK, I think since the crisis they have turned negative quite often. This is often due to changes in demand and supply dynamics, normally due to regulation or practical trading issues. For example, under Basel II rules CDS were capital-relief instruments because they allowed banks to compress regulatory capital for credit risk, but since then Basel rules have changed (Basel III now) and the favorable treatment of CDS has been restrained, driving down CDS trading significantly $-$ before the crisis, I believe I read somewhere between 50% to 80% of CDS trading was driven by capital-relief trades by banks; unfortunately I am unable to find the source.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.