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Why the Basis Risk in High Yield Credit?

The big theme in credit right now is high yield pain. There's no mistaking this pain right now. Credit in torment always looks like an avalanche.

One of the most obvious reasons for the pain is that regulatory reforms effect the depth of market making in a big way. Market makers are taking the current weakness as the catalyst to off-load risk. The result is a disconnect between cash and synthetic in risky credit. Here's a deeper dive into this trading anomaly.

Barclays US Credit Alpha, 31 October issue susses out that the CDX NA HY index has underperformed US cash high yield bonds by an average of 2.2% a year over the last five years. It gets worse: the analyst responsible for the research, Jigar Patel, calculates that the difference between returns on Barclays’ cash high yield index and the synthetic index has varied between 6.3 percentage points in 2011 (cash outperforming synthetic) and -7.9 percentage points in 2013 (when CDX NA HY outperformed). That’s eye-popping.

The paper highlights the index-single name skew, the difference in composition of the two indices, and interest rates as the drivers for the basis risk. To my thinking, there is another driver as well.

Different CDS indices behave in very different ways. CDX IG indices are used solely in bond land. When you have cash and no appealing cash bond available, you dump said cash in to a short CDS IG position, namely main, but others as well. It’s a liquidity absorber until something better comes along. The high-yield CDS product attracts a diverse pool of participants, not just in bond land. People use CDX HY to hedge against stocks and even commercial real estate. This increases volatility in the index but not the cash bonds. What you have is the potential for the derivatives start acting very differently than the underlying bonds.

Using a CDS index to hedge a position is less costly from a funding perspective, and it would make sense that someone wanting to hedge a high-yield bond position would turn to single-name CDS exposures. This may goose the synthetic market a bit in the short-term. But as the synthetic index becomes increasingly less precise as a hedging tool the decision will be to sell the cash bond. And a low-volatility cash market with no hedging possibilities means a rout.

Pretty much what we have been seeing since September, yes?

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