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would be better buyers of the bond and buyers of protection to maturity to lock in the positive carry.

Factors that widen the basis (positive basis):

• Strong demand from protection buyers such as banks or hedge funds
• Bonds can usually be funded in the repo market at or around Libor.
• If the bond becomes special the investor holds a repo market option that makes the bond more attractive than the CDS and tends to widen the basis (short positions in bonds cannot be locked in for years because of a nonexisting repo market).
• Deteriorating credit quality and increasing spreads/basis volatility or equity volatility (CDS = high beta instrument).
• Assets trading below par, that is an investor who pays $80 for $100 face value has less credit exposure than a protection seller at par. Therefore, the protection seller would demand a higher premium (spread) than the bond.
• Convertible bond issuance may lead to hedging credit risk to unlock “cheap” equity volatility.
• The cheapest to deliver option is a structural factor, which tends to widen the basis (protection buyer is able to deliver any qualifying loan/bond).

The default basis can also be viewed as a risk indicator. In general, the sale of default protection should be more attractive than purchasing a bond when the basis is high relative to the equity volatility of the firm and vice versa.

Make sure you use the proper credit strategy

Basis trades/Convertible bond hedging: As an example the basis for Fiat widened massively following issuance of a 2.2 billion convertible and deteriorating credit sentiment at the end of 2001. It is worth mentioning that the negative basis trade (long cash, long protection) is not entirely risk-free. If the bond is actually restructured at the time of default it is no longer deliverable. The risk-free positive basis trade cannot be set up till maturity because one is not able to lock in the repo rate of the bond (short cash, short protection).

Capital structure arbitrage: These might be strategies where investors take a position in a default swap versus an equity put option. If equity is undervalued, CDS levels are tight and debt is rich the following strategy appears to be appropriate. For example, selling out-of-the-money puts versus buying protection allows to position for a rally in the stock/declining equity volatility and to “hedge” this opinion against the risk of the widening of spreads on the company’s debt. The option premium earned is used to fund the CDS, with positive or negative carry. It is important to realize that this is not a pure arbitrage or risk-free trade.

Improving credit quality and decreasing spreads

The factors that drive the widening and the tightening of the basis are explained below:

Factors that pull protection tighter (negative basis):

• Strong demand from protection sellers because of the unfunded nature of CDS and a lack of desired exposure/liquidity in the debt market.
• Synthetic CDOs can drive default swap spreads tighter because the manager needs to sell protection in order to buy synthetic credit risk into these structures.
• The existence of a default swap curve in 1, 3, 5 and 10 years can offer investors a broader range of maturities to construct a better portfolio.
• Assets trading above par, that is, the protection seller is exposed to a lower amount than the cash investor.
• Improving credit quality and decreasing spreads/basis volatility (CDS _ high beta instrument).

If a credit event occurs…

Selling short-term and buying long-dated protection leaves a forward short position, which would benefit from a steepening in the credit curve and vice versa.

Senior versus subordinated CDS strategies: The senior-to-sub spread differential in CDS is driven fundamentally by expected recovery values. If senior spreads are half those of subordinated, then the expected senior loss following default is half that of sub. A 50 percent senior recovery (50 percent loss) would imply a 0 percent subordinated recovery (100 percent loss) A potential strategy is to sell subordinated protection and to buy senior protection (weighted). It offers the chance to unwind at a profit if the seniorto-sub ratio mean reverts to historical averages (positive carry trade). If a credit event occurs, the payoffs will reflect the actual relative recoveries in sub and senior debt.

Protection related to credit events

CDS are used to transfer the credit risk of a reference entity from one party to another. One party (the protection buyer) pays a periodic, fixed premium to another (the protection seller) for protection related to credit events on the reference obligation. If there is no credit event, such as default during the life of the swap, these premiums are the only cash flows . If a credit event occurs the protection seller is obliged to make a payment to the protection buyer. For physically settled contracts, following a credit event, the protection buyer delivers the defaulted reference obligation.

Cash settlement (par minus market value) is the alternative to physical settlement and is used less frequently in standard CDS but overwhelmingly in tranched CDOs. The 2003 ISDA definitions further clarify the three types of credit events:

• Bankruptcy
• Failure to pay
• Restructuring.

Just like cash bonds or loans, CDS transfer credit risk. To remove the interest rate component of a cash bond, a synthetic floating-rate note can be created via an asset swap which eliminates the duration and convexity exposure of the cash bond. An unfunded position in the bond would have to be financed in the repo market. A CDS is equivalent to a financed purchase of a bond with an interest rate hedge (selling protection through a CDS or buying a corporate bond, asset swapping the coupon to floating and financing the holding in the repo market).

When a credit curve is steep

On the other hand, if one has a negative short-term view on a credit but believes it to survive for the next 5 years, its credit quality will improve significantly. This view can be expressed via buying a long-dated 30-year par asset swap and buying 5-year protection on the single name thereby creating a long forward spread position (or buying short-dated default protection and selling longer dated default protection). This position would benefit from a flattening of the credit curve.

A steep credit curve implies a steep forward credit curve. A forward default swap is buying or selling protection for the given maturity at a given point in the future at the forward CDS spread. For example, Munich Re senior 2-year protection is at 21 bp and the 7-year protection trades at 34 bp. Selling 2-year protection and buying 7-year protection results in a 5-year CDS two years forward (2 _ 5 spread) at a level of 40 bp.

How to pick the right credit option

Directional trades: This refers to a situation where the CDS market can be used to take a low-cost bearish view because of a negative basis. If the basis is positive and has widenend for “technical” reasons, it possibly represents an opportunity from a hedging-driven market dislocation. Next post provides an example for Siemens.

Spread trades: Investors who are positive about France Telecom relative to Vodafone can express this outperformance view via selling protection in France Telecom versus buying protection in Vodafone. Depending on the chosen credits this could result in high positive carry trades.

Curve trades/Forward trades: As an issuer’s credit quality deteriorates, the spread curve of the issuer moves from being upward-sloping to inverted. Default curve inversion may present an opportunity to shorten maturity and enhance yield. Curve inversion in the default market also allows investors to purchase forward protection at lower levels. This can be achieved by buying longer dated protection and selling shorter dated protection.

The phase of the credit cycle

According to our correlation matrix high yield is best comparable with equities. The value of $100 invested in January 1987 in high yield and the S&P 500 Index. It can be said that investors realized similar returns over the period Jan. 1987–Dec. 2003. It brings more clarity into the relationship between high yield and equity markets. Obviously both markets are affected by similar macroeconomic factors, so that they show parallel fluctuations in risk. But it is important to note that high yield experienced less risk over this period, meaning that high yield returns experience less volatility than that observed with equities.

It shows historical yields in the high-yield market versus 10-year Treasuries and BBBs. The spread differential varies significantly depending on the phase of the credit cycle.

The advantage of credit brands

Before considering decisions that can build and strengthen brands, it is helpful to understand what advantages they offer. The value of a brand lies in the understanding or trust of customers. This leads to the first advantage: pricing. A successful and established brand can command a price premium that exceeds any extra cost in terms of production and marketing, derived from the element of trust that a brand provides.

Research in the UK has shown that in many cases consumers would be prepared to pay 30% more for a new product from a trusted brand than for an unnamed one. This is particularly true in the highly competitive food industry.

Distribution advantages are another benefit, as an established brand can ensure that manufacturers get the best distributors in terms of quantity and quality. This is because the distributors are more likely to be receptive to a new product from an established brand, in much the same way (and for similar reasons) as their consumers. This is particularly useful for new products. Again, this is because of the element of trust and reliability associated with brands.

The concept of brand identity or image is valuable as it reinforces the product’s appeal. For example, the Rolls-Royce brand has a stately identity and is associated with the values of craftsmanship, tradition and prestige. Volvo has a different brand identity and set of associated values, including safety, functionality and family-orientation. These identities reinforce their appeal to their particular market segments.

When markets decline, however, brand identity can become a handicap, linking the product to an unfashionable past.

The significance of credit brands

A brand is a design, name or identity that is given to a product or service in order to differentiate it from its competitors. Brands are likely to remain a potent force in the future, not least because, in an increasingly unclear and uncertain world, they help customers understand what they are buying or are being offered. If you buy a Rolls-Royce, for example, you expect certain brand values such as quality, reliability and prestige.

Brands are complex assets, and like people they possess, to some degree, distinguishing features. One increasingly popular method of managing brands is to view them as having “personalities”. The Rolls-Royce brand has a high-class, high-quality appeal throughout the world, and retailers such as Wal-Mart and K-Mart built their reputations on homely convenience and low price. It is this concept of brand personality that highlights their power.