Basis trades in credit - buying a cash bond and a credit default swap (CDS) on the same company simultaneously - can provide high returns with little risk, say fund managers at Assenagon Asset Management. Such trades were common among hedge funds and proprietary trading desks that have now left the market. Assenagon has been using a safer buy-and-hold strategy designed for new types of investors such as pension funds and insurance companies.

"You invest in bonds ... but you don't have the risk of defaulting because you are buying protection in CDS on the other side," said Assenagon fund manager Wolfgang Klopfer. Basis trades profit if the bond pays out more than the investor spends every year for the cost of the CDS. Many hedge funds and bank proprietary trading desks used to specialise in basis trades, seeing them as short-term, highly leveraged arbitrage bets.

But these arbitrageurs suffered heavy losses as the basis - the spread on the bond minus the cost of the CDS - continued to widen to unprecedented levels last autumn. "What we do is to make safe trades available to real-money people," Klopfer said. "We are doing it with very disciplined risk/return profiles." Fund managers Klopfer and Jochen Felsenheimer invest for the long term and keep leverage typically to 20 to 30 percent of the investment, with a maximum level equal to the amount invested.

Copyright Reuters, 2009