CMBS/CDS Basis Trade Finds Takers

As investors become comfortable trading single name credit default swaps on commercial mortgage backed securities, a plain vanilla trade is rapidly finding favor. The trade--which Goldman Sachs, Merrill Lynch and JP Morgan are reportedly out front in booking--is known as "buying the basis" and involves an investor buying the cash CMBS at swaps plus 31bp and then hedging the position with a single-name CDS on the same bond that costs 11bp.

In asset backed trades, if the CDS premium is less than the asset-swapped bond spread, the basis is described as negative. In the current climate, the investor gains a carry of 20bp spread. Investors in this trade could be out of the money if the negative basis widened, but benefit if the basis tightened.

The trade is advantageous to the regular CMBS investors, such as insurance companies, in a credit crisis, as there likely would be more investors wanting to buy CDS protection. This would mean that a potential imbalance in CDS demand could widen the CDS protection and tighten the basis in the position's favor.

The trade also works because of the negative basis due to the financing advantage of a CDS position that comes from the current mismatch between the fixed-rate CMBS position and the CDS contract, traders added.

Analysts noted novice CMBS derivatives investors should beware that at least part of the basis reflects the prevailing term financing rate and the swap spread on an interest-rate balance guarantee swap. The merit of this carry position should really be determined based on the financing available to the investors and their assessment of how the basis could move in the future, said Darrell Wheeler, managing director at Citigroup.

Both traders and investors said that there was no real trading history between the two products and the trade is still a gamble.