medium · Corporate Credit Analysis ratings
An analyst observes that a BB-rated bond trades at a spread of 450 bps, while a BB-rated Credit Default Swap (CDS) trades at 525 bps.
What is the CDS-bond basis, and what does a positive basis typically signal to a credit analyst?
- The basis is +75 bps; it signals that it is more expensive to buy protection than to hold the credit risk, potentially due to high demand for hedges.
- The basis is 0 bps, since textbook arbitrage mechanics are always assumed to force CDS and cash bond spreads to converge exactly to parity.
- The basis is -75 bps; it signals that the underlying cash bond is meaningfully undervalued relative to prevailing CDS market pricing on this credit.
- The basis is +75 bps; it signals that the issuer is very likely to be upgraded soon by the major credit rating agencies currently covering this name in the market.
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