Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a negative basis trade on Windstream Corp

Aggressive high yield bond buying came back in fashion recently as bond inflows shot upwards and Windstream's 2016 bond offers a great opportunity. Fundamentally we have been bullish on Windstream's credit spread for some time now and believe the best place to express that view is in a negative basis trade. The company's 8 5/8s of August 2016 bond trades at a substantial discount to its five-year CDS and we recommend buying the bond hedged with its CDS with a negative basis of -233bp.

Windstream raised its free cashflow forecast for the year when it reported second-quarter earnings last month and, after reviewing its numbers, we find Windstream's five-year CDS trades around 150bp wide to fair value. The company's tight equity-implied spread, increasing revenues, high operating margins (greater than 60%) and stable interest coverage drive our stance on the credit.

Windstream's interest coverage remained between 3.5-4.0x for years and continues to do so. Also, though recent acquisitions certainly helped, revenues increased sequentially for the past three quarters and are up 25% year-on-year, while margins remained well above 60% (Exhibit 1). As long as the economy avoids a double dip, we believe Windstream will continue to perform admirably.

That said, the size of the negative basis and reduced exposure to credit spread fluctuations make the combined bond-CDS exposure more attractive than an outright position. Thus, we believe alpha is best generated through a negative basis trade with Windstream's 5 5/8s of August 2016 bond.

Windstream's 8 5/8s of August 2016 bond CDS-implied fair value is US$115, which makes its offer US$11 cheap. Exhibit 2 compares the bond z-spreads with the CDS term structure and shows that the recommended bond is indeed trading wide of the closest-maturity CDS with a basis of -233bp.

The combined position is default-neutral; however, there is a slight maturity mismatch because the bond matures on 1 August 2016 and the CDS expires on 20 September 2015. We expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

The underlying idea of the negative basis trade is that credit risk is overpriced in the bond market relative to the CDS market. The investor buys a risky bond - and thus is paid to take credit risk on the issuer - while paying for credit risk in the CDS market by buying protection on the issuer.

There are many drivers of the basis, both technical and fundamental, which we explain in our Trading Techniques articles. Eventually, the prices for credit risk in the two markets should converge, resulting in an arbitrage-like profit. In the interim, the investor earns positive carry because the credit spread that is collected in the cash market is greater than the spread that is paid in the CDS market.

Position

Buy US$10m notional Windstream Corp 5 Year CDS protection at 355bp.

Buy US$10m notional (US$10.4m proceeds) Windstream Corp 8 5/8s of Aug 2016 at US$104.00 (T+600 bp; z-spread of 618bp) to gain 263bp of positive carry.

The appropriate interest rate is dependent on the portfolio in which the trade is held.

For more information and regular updates on this trade idea go to: www.creditresearch.com

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Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).