The Negative CDS-bond Basis and Convergence Trading During the 2007/09 Financial Crisis

This paper studies the CDS-bond basis, i.e. a measure of price discrepancies between CDS and bonds spreads, for a sample of investment-graded US firms. Results show that during the 2007/09 financial crisis the basis was time varying and negatively correlated to: the “Libor-OIS” spread, a proxy for the increased funding cost and risk in the interbank lending market, to measures of “bond value uncertainty,” which proxy for the increase in “haircuts” and to the “OIS-Tbill” spread, a proxy for the “flight-to-liquidity” and its related liquidity premium. Moreover, large losses erased the capital used to fund margin requirements and forced convergence traders to close their positions prematurely, thus amplifying large shocks