In its latest “Credit Market Outlook and Strategy” research piece, JP Morgan recommends a negative basis trade ‘with a twist’ on troubled casino operator Harrah’s Entertainment. The bank highlights that there appears to be a mispricing between Harrah’s senior 10.75% bonds due 2016 and credit default swaps that reference subordinated bonds.

JP Morgan recommends buying senior bonds and subordinated CDS, expecting different recovery values from the two products in default. The trade does not lose money in default, says the bank, and earns money if the basis becomes less negative.

JP Morgan illustrates buying the Harrah’s bond for $70.50 and buying CDS protection for 42% upfront and 500bp annual coupon. The analysts size the trade as default neutral today. They assume a 50% recovery rate on the senior bonds and a 25% recovery rate on the subordinated bonds.

In a default scenario, the loss on the bond would be $20.5, multiplied by $10 million notional, or $2.05 million. The trade will earn 75% on the CDS in default. After incorporating upfront costs of 42%, it nets 33% on the CDS trade. On $6.21 million of CDS protection, the gain in default will be $6.21 million x (1-25%-42%) = $2.05 million, exactly offsetting the loss on the bond. Thus, to protect against a default, an investor must buy $6.21 million CDS for $10 million face of bonds.

On the bonds investors would earn the 10.75% coupon, partially offset by an assumed 4.25% annual funding cost. In CDS, investors pay the 500bp coupon plus the 4.25% funding cost to fund the upfront payment. The net annual carry is positive $350,000. If there are defaults in future years and the recovery rate is 45%, the profit will be the annual carry earned. The investor desires a high recovery rate on the senior bonds, and a low recovery rate on the subordinated bonds. If basis becomes less negative, the trade should be profitable.