Trends in credit basis spreads
Abstract: Market participants and policymakers were surprised by the large, prolonged dislocations in credit market basis trades during the second half of 2015 and the first quarter of 2016. In this article, we examine three explanations proposed by market participants: increased idiosyncratic risks, strategic positioning by asset managers, and regulatory changes. We find some evidence of increased idiosyncratic risk during the relevant period, but limited evidence of asset managers changing their positioning in derivative products. Although we cannot quantify the contribution of these two channels to the overall level of spreads, the relative changes in idiosyncratic risk levels and in asset manager derivative positions appear small compared with the observed spreads. We present the mechanics of the CDS-bond arbitrage trade, tracing its impact on a stylized dealer balance sheet and the return on equity (ROE) calculation. We find that, given current levels of regulatory leverage, the CDS-bond basis needs to be significantly more negative than pre-crisis levels to achieve the same ROE target.
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Provider: Federal Reserve Bank of New York
Part of Series: Economic Policy Review
Publication Date: 2018