Basis trade will yield unlevered returns for minimal risk, says Morgan Stanley

In research published last week, Morgan Stanley notes that the conventional wisdom of credit default swaps widening relative to bonds in a negative environment no longer holds in the current cycle, where liquidity issues dominate the markets. The basis, they argue, has moved from being a trade to an asset, where investors are able to earn unlevered return for virtually no credit risk.

Because both dollar price and credit curve shape influence the fair value for a basis relationship, extreme negative basis on stressed investment grade names should be taken with a grain of salt. With a negative basis, the trade is most logically placed in the loan space, although this is less attractive than many investment grade opportunities. Moreover, convenant rights, which historically underscored the strong performance of the loan asset class, is currently not reflected in the price.