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How you can use a credit default swap price



Credit default swaps (CDS) can be used in a number of different ways by both institutional as well as retail investors. Below we highlight one example of how to use a CDS price to help ascertain appropriate pricing and value in a corporate bond.

This example makes use of Example 2 on the example page. In Example 2, the 5-year CDS price (Note all CDS prices on CreditLime are currently by default 5-year prices) for Honeywell International (ticker symbol: HON) is 31.1 basis points on March 9, 2011. 31.1 basis points (31.1 bps) is equivalent to 0.311% in percentage terms or when rounded is 0.31% (1 basis point is 1/100 of a percentage point).

Say it is the same day and you are a bond investor who was offered the chance to buy this "HON 5.4 03/15/2016" bond from your broker-dealer or bank at a yield of 2.50% (price of US$113.55). This is a 5-year corporate note issued by Honeywell International Incorporated paying a 5.4% semi-annual fixed rate coupon maturing on March 15, 2016 (Bond CUSIP: 438516AP1). Before deciding whether to purchase this particular bond, one of the things you will want to know is whether the price the broker is trying to sell you the bond at is a ripoff or not.

To do this, you can use the current CDS price (or the most recent one that is available) along with the current reference swap rate to figure out if the offer price is appropriate or not. In this case, Honeywell is an American company and this is a $US dollar bond issue so you can use a US 5-year swap rate as the appropriate comparison because the 5-year Honeywell bond maturity approximately matches the 5-year Honeywell CDS term which matches the 5-year maturity of the US interest-rate swap.

An interest-rate swap (or simply "swap" - as opposed to a credit default swap or simply "CDS") is a type of derivative used by investors to convert a 'fixed' rate payment, such a bond's semi-annual fixed interest payments, into a series of 'floating' rate payments or vice-versa. The reason for wanting to use the interest-rate swap as a benchmark - as opposed to using the risk-free rate (government bond yield) of the same maturity - is to remove the interest-rate component of a bond's yield or rate of interest and get a more pure measure of how much of a bond's yield is actually related to its underlying credit risk.

The US 5-year swap rate on the same day (March 9, 2011) can be found here and was 2.38%. Now given this reference (benchmark) swap rate, you can do a simple spread calculation to find out what the difference between the extra yield on the Honeywell bond is and whether this is appropriate or not. The calculation is shown below:

Spread = Yield on corporate bond - Swap rate (of same maturity).
0.12% = 2.50% - 2.38%

Now that you have calculated this spread (also known as the interpolated spread or i-spread), you can use that to compare with the CDS spread. In this case the i-spread of 0.12% is less than the 0.31% CDS spread and therefore it would actually cost you an extra 0.19% (0.12% - 0.31% = -0.19%, or 19 basis points) in spread to buy the actual Honeywell (cash) bond and hedge out the credit risk using the (derivative) Honeywell credit default swap. This 19 basis point difference is also referred to as the "basis". In this example, the Honeywell 5-year CDS basis of 19 bps (calculated using i-spreads) is slightly positive. The directional value of this basis (positive or negative) is calculated by taking the CDS price and subtracting out the bond spread (i-spread in this case).

This basis figure is a useful number for many investors in deciding whether or not a bond is properly priced. Generally speaking (in normal situations), most corporate bonds will have a "positive basis" or "zero basis" because if a bond investor could purchase the corporate cash bond and then buy full credit default protection (via a CDS) on the bond AND still receive some extra "risk-free" yield (a so-called "negative basis" or risk-free or arbitrage-type trade) then everyone would do it and drive up the demand for such a trade (and in turn drive up the cost for such CDS protection) eventually negating any negative basis that could be had.

Having said that, there are usually always cases where a negative basis exists at a given time in some companies or even some sovereign countries for various entity-specific or structural reasons. Many more bond investors have been looking at and/or using such "basis strategies" and "basis trades" to add value and incremental yield to their fixed income portfolios. "Negative basis" trades are a popular strategy for some hedge funds because they can buy the bond (which they may believe to be relatively undervalued) and then also buy the credit default swap for default or bankruptcy protection at a lower cost (spread) than what they are already earning on the cash bond. So long as there is no counterparty risk on the CDS trade, these strategies are effectively trying to earn a "risk-free" return equal to the size of the negative basis.

Do note that such theoretical "risk-free" trades often involve a number of inherent assumptions - in this case things like margin requirements, counterparty quality, calculation error, liquidity etc. - which can, and sometimes do, in fact prove to be wrong. Because of this, even "risk-free" trades (like pretty much everything else in life) often involve some element of risk despite however minimal in magnitude or quantity it may be. A 1 in 1 million year "probability" of loss occurring is still a risk even if the probability is small.

Competitive forces and supply and demand imbalances will usually "correct" the larger negative basis' (i.e. for example those with a basis of > |1%|) over time. Small negative basis', however, can continue for extended periods due to other factors such as non-uniformity over the methods used to calculate or derive the basis number (one calculation might indicate a negative basis while by another calculation the basis is positive), differences in liquidity or supply/demand between the actual cash bond in question and the respective credit default swap, goverment and/or regulatory issues, [CDS] counterparty risk, margin requirements on the CDS, value in potential voting rights or other embedded options, and other systemic or market-based risks like short-term panic-induced buying/selling and markets being cornered or squeezed.

Below is a small chart illustrating the simplified general rule-of-thumb for evaluating or comparing bond spreads with CDS prices.

Scenario
if...
is...
than...
then...
1 i-spread LESS CDS spread positive basis (bond possibly overvalued or CDS undervalued)
2 i-spread MORE CDS spread negative basis (bond possibly undervalued or CDS overvalued)


So for this example, Honeywell has a slight positive basis of 19 bps. On its own the 19 bps may not mean too much to you but if you watch this basis every day over longer periods of time, you can ascertain whether or not the bond may be over or under-valued relative to its average level of positive basis. If the Honeywell positive basis has been 30 bps over the last year and you see that it currently trades at a positive basis of 19 bps (or even better yet - falls further and begins trading at a negative basis) then that could be a good time to buy the bond under the belief that it is relatively undervalued compared to historical trading levels, ceteris paribus, and will revert back to the old historical levels.

Remember despite the name "positive" or "negative", from the point-of-view of the corporate cash bond investor, a lower "positive" basis number or more "negative" basis value is the better or preferable time to buy or go "long" the bond. The opposite of this situation, when there is a high "positive" basis, is the better time for the corporate bond investor to "sell" or "short" the bond. Actually shorting cash bonds in practice, however, can be hard to do for a number of reasons hence investors can also or in combination use credit default swaps as an alternative way to put on the same intended trade). Buying a CDS ("buying protection") is roughly equivalent to "shorting" the cash bond while Selling a CDS ("selling protection") is roughly equivalent to "going long" the cash bond since you are taking on or exposing yourself to the credit risk of the underlying reference entity. Putting the actual numbers can sometimes help understand the comparison. In the Honeywell case, since the CDS price is 31 bps and the bond spread is only 12 bps (less than half the CDS price), an investor would rather sell the CDS and make 31 bps per year for 5-years to take on the risk of losing all their money if Honeywell goes bankrupt instead of buying the actual Honeywell bond and only earning 12 bps to take on that same risk. As the Honeywell example demonstrates, from the point-of-view of the CDS investor, a "positive" basis value is the better time to sell a CDS or go "long". If you wanted to combine this Honeywell CDS in a strategy with the bond to minimize your risk and simply bet on the 19 bps difference converging, you would also try to short the bond if possible. In such a combined trade, you would end up receiving 31 bps from the CDS (the "long" side of the trade) and pay 12 bps to whoever you borrowed the Honeywell bond you shorted (the "short" side of the trade) and make a net 19 bps difference. If this difference reduces, it means that either the CDS spread fell (is now less than 31 bps) or the bond spread rose (more than 12 bps) or both and you could sell out of your positions at a profit. The unspoken risk here is that instead of the difference reducing, it could actually increase in which case you would lose money. Since retail investors can only participate on the cash bond side of things (only institutional investors can actually trade CDS), retail investors mostly focus on the informational value of the basis (particularly lower positive basis' or the existence of a negative basis) to help determine bonds to buy or the time to buy and sell bonds.

As another way to double check whether the Honeywell bond being offered to you at a price of $113.55 and yield of 2.5% is in line with other trades in the market and double-check on a comparable-basis whether or not you are getting ripped off, you can also check the TRACE system for a listing of the latest bond trades and compare the basis you paid for your bonds with what other investors paid. As the sample screenshot below shows, there were 3 trades in that 5-year Honeywell bond (HON 5.4 03/15/2016) at spreads between 2.488% and 2.581% that day (March 9, 2011). At the original offer price of 2.5%, it appears that buying a bond at that offered level would be on the more expensive side of the market (with the most expensive trade being at 2.488% (a positive [CDS] basis of 20.2 bps) and the cheapest trade being at 2.581% (a positive [CDS] basis of 10.9 bps).

HONEYWELL INTL INC 5.4% 03/15/2016 Trades
CDS tweet


NOTE: i-spreads, z-spreads and CDS basis

Now that you know one way to use a CDS price, go lookup another CDS price now and see if any other of your existing bonds may be over or under-valued. The previous explanation has been provided for information use only and does not make any sort of trade recommendations. For any other questions, please contact CreditLime .








2011 - CreditLime