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CDS-bond basis and bond return predictability

Author

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  • Kim, Gi H.
  • Li, Haitao
  • Zhang, Weina
Abstract
We examine the predictive power of the CDS-bond basis for future corporate bond returns. We find that residual basis, the part of the CDS-bond basis that cannot be explained by a wide range of market frictions such as counterparty risk, funding risk, and liquidity risk, strongly negatively predicts excess returns. Controlling for systematic risk factors, including credit risk and liquidity risk, we find that a bond portfolio formed on the residual basis generates a significant abnormal bond return of 1.79% at the 20-day horizon. The abnormal returns due to the residual basis reflect mispricing rather than missing systematic risk factors. These results are robust to different horizons and sample periods and to the various characteristics of bonds. Overall, our results imply a beneficial role of CDS in the bond market as the existence of mispricing between CDS and bonds results in a subsequent price convergence in bonds.

Suggested Citation

  • Kim, Gi H. & Li, Haitao & Zhang, Weina, 2016. "CDS-bond basis and bond return predictability," Journal of Empirical Finance, Elsevier, vol. 38(PA), pages 307-337.
    • Handle: RePEc:eee:empfin:v:38:y:2016:i:pa:p:307-337
    DOI: 10.1016/j.jempfin.2016.07.006
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    2. Gilchrist, Simon & Wei, Bin & Yue, Vivian Z. & Zakrajšek, Egon, 2022. "Sovereign risk and financial risk," Journal of International Economics, Elsevier, vol. 136(C).
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    4. Chongsoo An & John J. Cheh & Il-woon Kim, 2017. "Do Value Stocks Outperform Growth Stocks in the U.S. Stock Market?," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 7(2), pages 1-7.
    5. Sung, Ming-Chien & McDonald, David C.J. & Johnson, Johnnie E.V. & Tai, Chung-Ching & Cheah, Eng-Tuck, 2019. "Improving prediction market forecasts by detecting and correcting possible over-reaction to price movements," European Journal of Operational Research, Elsevier, vol. 272(1), pages 389-405.
    6. López-Herrera, Francisco & Santillán-Salgado, Roberto J. & Cabello, Alejandra, 2019. "Latin American Corporate Emerging Markets Bond Indices (CEMBIs): Their recent evolution," Global Finance Journal, Elsevier, vol. 41(C), pages 104-112.
    7. Guesmi, Sahar & Ben-Abdallah, Ramzi & Breton, Michèle & Dionne, Georges, 2019. "The CDS-bond Basis: Negativity Persistence and Limits to Arbitrage," Working Papers 19-4, HEC Montreal, Canada Research Chair in Risk Management.
    8. Pereira, John & Sorwar, Ghulam & Nurullah, Mohamed, 2018. "What drives corporate CDS spreads? A comparison across US, UK and EU firms," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 56(C), pages 188-200.

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    More about this item

    Keywords

    Credit default swaps; CDS-bond basis; Basis arbitrage; Corporate bonds; Financial crisis; Limits of arbitrage; Return predictability; Price convergence;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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