This document explores the relationship between credit default swaps (CDS) and bond credit spreads for various countries. It finds that while CDS and bond spreads both track credit risk, they do not always move in tandem. Bond spreads sometimes lead CDS in recognizing increased credit risk, while at other times CDS lead bond spreads. The differences can be attributed to liquidity, funding complexity, market structure, and counterparty risk factors between CDS and bond markets. The analysis concludes that arbitrage opportunities between CDS and bond spreads are fleeting and risky due to the potential for abrupt changes in their relationship.

1. Credit Default Swaps (CDS) vs
Bond Credit Spreads
a visual exploration through the
Blogosphere
Gaetan Lion
March 21, 2012

2. CDS vs Bond Credit Spread
You would think both those metrics should
closely track each other since they track
the same thing: credit risk.
Apparently there are many reasons why
the two can differ due to relative
differences between the two in liquidity,
funding complexity, market structure, and
counterparty risk among other factors.

3. PIGS countries
As shown the Bond Spread seem to actually lead (increase higher, earlier)
than the CDS in early 2009 in both Greece and Portugal and even Spain.

4. Morgan Stanley CDS vs Bond Spread
Between 8/31 and 11/24/2011 the Bond Spread has been much higher than the
CDS. For another time period, the reverse may have been observable.

5. Here Bond Spreads take the lead (remain high) in early 2009, to lag
just a bit in late 2009. By February 2010, there is very close
convergence between the two.

6. As the title suggests, Italian bond spreads, after lagging in early 2010,
take the lead in mid 2011 relative to CDS. The latter take a long time to
catch up and have not yet as of January 2012.

7. Here Spain CDS clearly lead bond spread for an entire year, until the
two reach pretty good convergence by second half of 2010.

8. Except for a couple of quarters in 2009, Belgian CDS are chronically
higher than Belgian bond spreads.

9. Conclusion
In view of the visual evidence, it does not
appear that CDS are chronically wider
than Bond Spreads or always lead Bond
Spreads in recognizing credit risk. Also,
the volatility of both appears to be similar.
Arbitrage opportunities between the two
appear fleeting and potentially dangerous
as the basis difference can abruptly switch
signs.

10. Very Different Risk for major US Banks

11. Interesting relationship?!