Many thanks to JP Morgan, which sent me the data for the above chart, which shows the CDS-bond basis for BBB-rated debt. In English, that means it’s the number you get when you take the CDS spread on BBB-rated credits (that’s the lowest investment-grade rating), and subtract the yield on those credits’ bonds.
The lower this number goes, the higher the arbitrage opportunity: you can buy a bond, hedge it with a CDS, and pocket the profits.
It’s not a perfect hedge, since there are counterparty risks involved, but they’re normally dealt with through margining requirements. Was the plunge in the CDS basis between September and December the result of a huge increase in counterparty risk? It’s possible: it’ll be very interesting to see what happens to the basis if and when these credits migrate to a CDS exchange with minimal counterparty risk.
It’s also far from clear whether the above chart is what was responsible for a large part of Merrill Lynch’s $15 billion in fourth-quarter losses. But remember that historically the basis has been positive, which means that Merrill’s traders might well have seen a juicy profit opportunity when the basis turned negative in 2008. After all, what were the chances it would get much worse?