CDS Hedge of a Corporate Bond Holding
A UK bank holds £25 million face value of five-year bonds issued by a large regulated utility. The bonds yield 5.60%, 320 basis points over gilts. The bank's internal credit limit for the utility is £15 million, so it wants to reduce its exposure by £10 million. Two options are proposed: (i) buy £10 million notional of five-year CDS protection on the utility at 250 basis points, or (ii) sell £10 million of the bonds and reinvest in five-year gilts yielding 3.00%. The bank funds its bond portfolio at SONIA plus 40 basis points; SONIA is 4.00%. The CDS requires initial margin of 5% and daily variation margin under a CSA. The bank's relationship manager warns that selling the bonds could damage the utility client relationship. The chief risk officer is concerned about basis risk between the bond and CDS and about the CDS counterparty's creditworthiness.
1. Calculate the negative basis and compare the annual net carry of the CDS hedge with selling the bonds and buying gilts.
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Negative basis = bond spread − CDS spread = 320 bp − 250 bp = 70 bp.
CDS hedge: The bank keeps the bond yielding 5.60% and pays 2.50% for protection. Funding cost = SONIA 4.00% + 0.40% = 4.40%. Net carry = 5.60% − 4.40% − 2.50% = −1.30%, or −£130,000 per year on £10m. Initial margin is 5% × £10m = £500,000; if that cash earns nothing, the funding cost is about £22,000 per year, taking net carry to about −£152,000.
Sell bonds and buy gilts: Gilt yield 3.00% − funding 4.40% = −1.40%, or −£140,000 per year. Before collateral cost, the CDS hedge is slightly better by £10,000 per year; after collateral cost it is slightly worse. Transaction costs and the relationship issue also matter.
2. Explain the basis risk and counterparty risk in the CDS hedge, and why the negative basis might persist.
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Basis risk arises because the CDS references the utility's credit, while the bond is a specific obligation. The bond-CDS basis can widen or narrow due to liquidity, funding costs, restructuring terms, or changes in the cheapest-to-deliver obligation. If the basis widens against the bank, the hedge may not offset mark-to-market losses on the bond. Counterparty risk arises because the CDS protection seller may default; daily collateral reduces but does not eliminate gap risk. The negative basis of 70 bp may persist because cash bonds can trade cheap relative to CDS due to dealer balance-sheet costs, repo funding, or a shortage of protection sellers. It may also reflect a convenience yield or the market's view of the utility's restructuring risk. The bank should not treat the negative basis as a pure arbitrage.
3. Recommend which route the bank should take, considering the credit limit, client relationship, and risk management.
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The CDS hedge reduces the credit exposure to the utility without selling the bonds, so it preserves the client relationship and avoids realising a loss on the bond position. It is also slightly cheaper than selling bonds and buying gilts before collateral cost. However, it leaves the bank exposed to CDS counterparty risk and basis risk, and the initial margin reduces the carry advantage. Selling the bonds is cleaner: it removes the credit exposure entirely and avoids derivative complexity, but it may damage the relationship and crystallises a loss if the bonds are underwater. Recommendation: buy CDS protection on £10m with a well-rated counterparty and a robust CSA, provided the bank can manage basis risk and collateral. If the credit limit is hard and the CRO is uncomfortable with derivative exposure, sell the bonds and explain the decision to the client. A blended approach - selling £5m and hedging £5m with CDS - may balance the relationship and risk concerns.