Hedging a bond with CDS and the remaining basis

Credit Default Swaps · Swaps Trading Guide

A CDS can reduce a bond’s default exposure without eliminating its interest rate, liquidity or contractual risks. The remaining difference is central to hedge analysis.

Match what can actually default

Check that the bond and CDS refer to compatible entities and obligations. A parent company and a subsidiary are not interchangeable. Seniority, restructuring terms and deliverability affect protection. Equal face amounts do not establish that every possible bond loss is covered by the swap.

Keep rate risk separate

A bond can lose value when government yields rise even if its issuer’s credit quality is unchanged. CDS primarily addresses defined credit risk, so it does not automatically hedge this interest rate sensitivity. It also does not guarantee that the bond can be sold promptly at a model price.

Interpret the bond CDS basis

A comparison between a bond credit spread and CDS pricing needs consistent maturity and valuation assumptions. Funding, liquidity, delivery options and different contractual protections can sustain a basis. Buying the bond and buying protection is not a guaranteed arbitrage merely because their quoted spreads differ.

Model the combined cash flows

Suppose a bond with $1,000,000 face value was bought at par, recovers $400,000 and is paired with perfectly matching CDS cash protection of $600,000. Principal is restored in this simplified default scenario. Premiums, financing, timing and any unmatched recovery assumptions still affect the outcome. A purchase above par would introduce an additional uncovered cost.

Try it yourself

A bond costs $1,050,000. In a simplified default it pays $400,000, and its CDS pays $600,000. What remains unrecovered before premiums and funding?

Show the worked answer

The combined recovery is $1,000,000, leaving $50,000 of the purchase cost unrecovered. The exercise shows why face value protection is not protection of every invested dollar.