Sovereign CDS-bond basis in Eurozone countries: an empirical analysis of equilibrium during the Covid-19 pandemic

Abstract

I analyze the theoretical no-arbitrage condition stating that the difference between CDS spreads and bond yields over a risk-free benchmark should be zero in equilibrium, as they depend on the same default probability. The study displays the main characteristics of CDS contracts and then uses the PECS (Par Equivalent CDS Spread) method to measure the CDS-bond basis before and after the Covid-19 pandemic outbreak in 2020. Then, a multiple regression analysis is conducted in order to identify the main factors that contributed to explaining the behavior of the basis. Drivers as liquidity, short selling frictions, exchange rates are considered, as well as the impact of the ECB's PEPP. The focus of this study is on a sample of “peripheral” and “core” Eurozone countries, as one of the objectives is to show how heterogeneously the pandemic impacted across different groups of countries.