That would be free μεσημεριανό in Greek.
And it’s not our translation — Citigroup credit strategist Hans Lorenzen actually uses the word in his latest note. In it, Lorenzen recommends investors jump on the negative basis which currently exists between Greek bonds and CDS on those bonds.
As a reminder, negative basis suggests the CDS spread is lower than the bond spread. A positive basis means the opposite, and tends to be the norm. In fact, according to Citi, the negative basis in Greek bonds of well over 100 basis points is ultra-unusual.
Though not unknown in recent months, as the below Citi chart shows:
These anomalies tend to be arbitraged out quite quickly by traders — which is why Citi thinks investors should get on it — ASAP.
Here’s the maths behind the trade:
If Greece were to restructure tomorrow, we believe the trade would perform strongly. Assume a Greek restructuring involved a 50% haircut. Crudely, you paid 75 for the bond, so you lose 25 points. You paid 21 points upfront for the CDS protection (assuming you pay 100bp running1), but you’d make 50 on the default, leaving you up 29 points on the CDS leg. The difference (29-25) is 4 points of net profit. In fact, that net profit doesn’t change with the recovery assumption – whether the recovery rate is 30% or 80%, your net P&L would still be 4 points.
Sounds like a free μεσημεριανό, right? Almost, but not quite.
There are some risks to the trade, Citi adds, though the bank reckons these are actually much smaller than the likelihood that the basis is quickly arbitraged away:
* Although CDS trading is margined today, obviously, you do run some double default risk (Greece and the bank you bought protection from default simultaneously), so choose your counterparty carefully.
* While the vast majority of Greek government debt is issued in €s, European sovereign CDS is most liquid in $. That leaves you with some currency risk, which means you may have to adjust your bond / CDS ratio from time to time. However, in the restructuring scenario any resulting downward pressure on €/$ would work in your favour.
* Just because the basis is wide, there’s nothing to stop it widening further in the short term. The mark-to-market can be very painful in the short term as anyone sitting on a negative basis position in Greece in May of last year will know (Figure 1). However, in the event it proved very short-lived. With forced selling less likely now that Greece has left most government bond indices already, we reckon the chances of similar basis dislocations in the future are diminishing.
From what we remember, Barclays Capital recommended a Greek negative basis trade back in May – when the five-year basis was hovering around 200bps…
(H/T The FT’s Richard Milne and Anousha Sakoui)
Related links:
What fresh basis the ECB hath wrought – yet again – FT Alphaville
Guest post: Quanto-fied, a sovereign CDS tale - FT Alphaville
On the non-existent basis of a (Greek) CDS ban – FT Alphaville