Greek basis trades, that is. About a year ago, banks first started recommending negative basis trades — which saw investors buying a (cash) Greek bond and then taking out insurance (CDS) on the holding. It only works once spreads in the CDS market are lower than in the cash market, something which rarely happens and tends to get arbitraged out quite quickly. To paraphrase Reuters blogger Felix Salmon, you are buying the bond, fully insuring it, and locking-in risk-free profits just by holding to maturity.
This basis strategy, however, is rather different. It’s a positive basis trade on Greece. That is, selling the bonds and CDS on the assumption that the difference between the two will narrow or disappear.
It’s the big new thing according to Mark Schofield at Citigroup, who takes a look “at the increasingly popular short CDS basis trade” in a piece of Friday research. And it’s all because of that pesky CDS issue, will it or won’t it trigger CDS payouts (or ‘credit event’) in a soft restructuring of Greece.
There has been a great deal of speculation lately as to what exactly constitutes default as a credit event. The ongoing stand-off between the German position, that appears to require immediate and significant private participation in any further support package, and the ECB and French position, which holds that a default should be avoided at all costs, has led to an increased interest in trades that position for a non-default triggering restructuring; selling the CDS/cash basis.
The premise of such trades is that being short the CDS and short the cash bond will be a profitable trade if there is a restructuring of the debt that is deemed not to be a credit event that triggers the payment on the default swap. What such an event might be is wide open to debate. Comments this week from ISDA that a debt swap to extend maturities is “typically” not a credit event and that debt roll-over is not a credit event provided so long as funds are repaid before being reinvested, have certainly triggered renewed interest in the short CDS basis trade but sabre rattling by the ratings agencies should not be ignored.
We fear that short CDS trades ignore a number of potential pitfalls. First of all, a debt maturity extension may alleviate short-term funding pressures, but it is highly unlikely to do anything to really reduce debt service burdens. As can be seen in Figure 5, a 5yr maturity extension simply reduces running yields to something in the order of 8-10%, but these are clearly unsustainable levels against a backdrop of weak growth…this makes an eventual reduction of some of the future commitments still highly likely. Second, any roll-over of debt would need to be entirely voluntary. In our view any significant coercion of bond holders is likely to be viewed dimly in a court of law. It is not clear to us why a sufficient number of bond holders would want to entirely voluntarily extend their risk profile unless there is a credible chance of strong economic growth and a significant fiscal correction. With the CDS basis in the tier 3 countries all now in negative territory, we view selling it here as a (very) long shot indeed.
Here at FT Alphaville, we hear that certain ‘smart money’ is actually doing the opposite trade now — buying Greek CDS on the premise that a credit event will be declared. Though even that seems risky.
BarCap’s Hellenic tale of CDS tail risk – FT Alphaville
Par-don me, what was that about Greek CDS? – FT Alphaville
Citi sees free lunch in Greek basis (almost) – FT Alphaville
What fresh basis the ECB hath wrought – yet again – FT Alphaville