CDS vs Bond Spreads

What Additional Return Does a Corporate Bond Offer Compared with a Risk-Free Instrument?

Bond Spread

A buyer of a corporate bond assumes the company’s credit risk.

If the company meets its obligations, the investor receives:

• the bond’s coupon payments;
• the principal at maturity.

If the company defaults, the investor may recover only part of the principal.

Because of this risk, a corporate bond normally offers a higher yield than a risk-free instrument.

For example, suppose:

• the yield on a five-year corporate bond is 7%;
• the corresponding five-year risk-free rate is 5%.

The bond’s additional yield is:

7% – 5% = 2%, or 200 basis points.

This additional 2% represents compensation for the risks assumed by the holder of the corporate bond.

What Happens If the Investor Also Buys CDS Protection?

Hull considers the following example:

• an investor buys a five-year corporate bond at par;
• the bond yield is 7%;
• the investor buys a five-year CDS to protect against the default of the same company;
• the CDS spread is 2%, or 200 basis points.

The investor receives 7% from the bond but pays 2% for CDS protection.

Therefore, the investor’s net annual return is:

7% – 2% = 5%

This is exactly equal to the risk-free rate.

In other words:

Corporate bond + CDS protection ≈ risk-free bond

What Happens in the Event of Default?

If the company defaults, the investor suffers a loss on the bond.

However, as the buyer of CDS protection, the investor receives compensation for the corresponding loss.

Under physical settlement, the investor can deliver the bond to the protection seller in exchange for its face value.

As a result, the credit loss on the bond is offset by the CDS.

Until default, the investor earned a net return of 5%. After receiving the principal through the CDS settlement, the investor can reinvest it at the risk-free rate for the remaining period.

Therefore, the combination of the corporate bond and CDS protection creates an approximately risk-free position.

The word “approximately” is important because, in practice, the terms of the bond and the CDS may not match perfectly.

Asset Swap Spread

Hull uses LIBOR or the swap rate as the relevant risk-free benchmark.

The excess of the corporate bond yield over the swap rate is called the Asset Swap Spread.

In simple terms:

Asset Swap Spread = Bond Yield – Risk-Free Rate

Therefore, in theory:

CDS Spread ≈ Asset Swap Spread

However, in practice, the two are not always exactly equal.

The difference between them is called the CDS-bond basis, which can be either positive or negative.

Because the price of the same risk should theoretically be equal across markets, the CDS-bond basis tends toward zero.

This relationship is supported by arbitrage.

However, in practice, the CDS-bond basis is not always a form of “free arbitrage.”

It is affected by funding costs, liquidity, counterparty risk, execution risk, and other market frictions.

Source:

John C. Hull, Options, Futures, and Other Derivatives, Chapter 24 — Credit Derivatives.