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Positive basis exists when the spread on a CDS is greater than the spread on its underlying bond. Where this situation exists, insurers can sell their government bonds via the repo market and sell CDSs on the same name, thereby benefiting from a premium generated from the CDS spread being greater than the coupon received from the underlying bond.
Emily Penn, London-based director, insurance asset-liability management advisory at Royal Bank of Scotland, says: "In Europe, a lot of government bonds are trading on a positive basis, so firms are being paid more to take on risk through CDSs than if they were actually holding the outright bond. Some insurers have looked to enhance yield by taking advantage of this distortion."
On February 26, the positive basis between French bonds and French CDSs was 34 basis points. For Italian bonds, the spread was 19bp, and for German bunds it was 100bp. This reflects a tightening of basis spreads from June 2012, when basis spread were 89bp, 98bp and 137bp respectively.
Because the arbitrage opportunities afforded by positive basis are by their nature very small, insurers would have to leverage their positions in order to reap material benefit, says Penn. "An insurer cannot massively leverage up the portfolio, but if the positive basis is attractive enough there will still be opportunities for yield enhancement," she adds.
But insurance asset managers caution that the complexity of these trades and the narrow window of opportunity offered by the temporary divergence of spreads make them difficult to include as a strategic part of an insurer's yield enhancement strategy.
John Roe, head of strategic investment and risk management at Legal & General Investment Management in London says: "I can see how positive basis trades add value, and I am perfectly comfortable with a skilled asset manager using it as a portion of a portfolio, but I think the systematic use of that runs quite a lot of counterparty risk".
Firms are able to write CDSs as long as they hold sufficient cash to meet the potential liability that would arise if the underlying asset suffered a credit event (either a downgrade or default).
The gains to be made from positive basis can also be eroded by the costs of the initial repo transaction. Kambiz Deljouie, director of asset and liability portfolio solutions at Aviva Investors in London, says: "Investing in positive basis effectively means shorting a bond. For corporates and financials this is not economically possible and in sovereign markets, for a Libor-based investor, earnings from positive basis can potentially be offset by the repo/Libor spread. So far, we have not seen many overwhelming transactions."
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