US CREDIT-Basis trades offer opportunity as bond sales hit

By Karen Brettell

NEW YORK, Nov 30 (Reuters) - New corporate debt sales are pricing at wider spreads as credit concerns weigh on the bond market, while credit default swaps are rallying.

This makes it an ideal time to profit from divergence between the spreads of both securities.

"Following a substantial rally in equities on Tuesday and Wednesday, a flood of investment grade credits seized the better tone to tap the market," Morgan Stanley analysts said in a report on Friday.

"These deals have come considerably wide to credit default swaps," they said.

As the new debt is sold the basis, or difference between the spreads of corporate bonds and credit default swaps, has turned more sharply negative. Negative basis occurs when default swap spreads are tighter than those of comparable corporate bonds.

Credit default swap spreads on average are trading 28 basis points tighter than comparable bond spreads, compared with 13 basis points a week ago, JPMorgan analysts said.

The negative basis of some companies is 60 basis points or more, with Washington Mutual Inc WM.N among the most negative at minus-167 basis points, they said.

When the basis turns negative, investors can buy a company's bonds and also buy protection with its credit default swaps to pocket the difference between the two spreads, while also taking on very little risk.

Around $25 billion in new corporate debt sales was announced this week, JPMorgan said. "New issue discounts are keeping bond spreads wide, while CDS has rallied due to short covering," they said.

"We believe negative basis will persist in the near future due to high funding costs and new bond supply pressure," they added. "Meanwhile, investors are likely to be cautious ahead of the Fed meeting, which could reduce the willingness of investors to be short."

The Federal Reserve is expected to cut interest rates when it meets on Dec. 11.

"During this year's credit crisis, the basis first moved positive, reflecting a well-rehearsed theme of past credit weakness, as CDS, which is a direct hedging vehicle, and more liquid to boot, moved wider faster than the cash market," Morgan Stanley said.

"But as the situation turned into a question of funding, we saw a significant reversal - certainly a "pain trade" in a market that had rushed to buy protection."

"For investors who are funded already, negative basis trades offer very interesting returns in excess of swaps, for virtually no credit risk," they said.

(Reporting by Karen Brettell; editing by Clive McKeef)