CDS-Bond Basis: An Empirical Study of European Souereign Credit Spreads

Abstract

We study the eurozone sovereign CDS-bond basis and evaluate the link between the sovereign CDS premiums and the corresponding bond yield spreads. We find statistically significant differences in determinants of sovereign credit risk in periods of market distress and in normal times between 2010 and mid-2021. We also confirm substantial heterogeneity among countries in the euro area and that creditworthy countries react differently in times of market distress compared to riskier nations. There is a sustained positive CDS-bond basis in countries like Germany and UK and a recurring negative basis for countries like Italy and Portugal. These results imply that limits-to-arbitrage partly can be explained by liquidity constraints, flight-to-liquidity, currency risk, and counterparty risk in the cash and derivative market.