‘Greek’ and ‘negative basis trade‘ used in the same sentence gives us the shivers.
But here you go. From Barclays Capital’s latest European Credit Alpha note:
Figure 2 [below] plots the 5y CDS minus the asset swap spread for various European sovereigns. Greek government bond spreads in particular have widened relative to CDS premiums, leading to a significantly negative basis. Consequently, potential returns available on Greek basis packages are substantial, particularly for a short-term credit event (Figure 3).
While the chart indicates a positive return even if the bond survives, it is important to note that in our calculation we discount cash flows at Euribor. Funding costs over Euribor will reduce returns accordingly. Indeed, future deterioration in funding costs for GGBs, which could lead to a further widening of the (negative) basis and a mark-to-market loss, is one of the key risks to the trade. Additionally, further downgrades to sub investment grade level by Moody’s and Fitch may lead to forced selling, potentially causing cash to underperform.
A key risk to the trade — no kidding.
Negative basis trades essentially involve buying a bond and then taking out insurance (CDS) on the holding — once spreads in the CDS market are lower than in the cash market. The trade is basically an arbitrage type-deal — profiting from the difference between the spreads.
And as you can see from the Figure 2 chart provided by Barclays, there really is an impressive difference between Greek CDS and Greek bonds at the moment:
But again there are risks.
Negative basis trades were of course made famous during the financial crisis, when banks had the brilliant idea of buying bonds and then buying CDS on them from now-defunct or bailed-out monoline insurers.
The trades ended up collapsing rather spectacularly.
(H/T Alea)
Related links:
On the non-existent basis of a (Greek) CDS ban - FT Alphaville
Who’s selling Greek CDS? – FT Alphaville