Understanding the performance of CDS indices compared with bond indices: Higher returns with lower risk?

CDS indices have generated higher returns than bond indices, and the return di↵erence is especially large in the high yield universe. The outperformance is surprising because CDS and bond indices are similar instruments to hedge or invest in corporate credit risk. This study therefore investigates the return di↵erence between CDS and bond indices for the investment grade and high yield universe from 2005-2017. The higher return of CDS indices cannot be explained by a higher volatility or di↵erences in exposure to well-documented risk factors, such as size and momentum. For high yield, di↵erences in weighting schemes and roll-down (a component of carry) are the main drivers behind the outperformance of the CDS indices. The return di↵erence between investment grade CDS and bond indices is much smaller and may even be negative depending on the chosen sample period. For both universes, using geometric compounding instead of arithmetic compounding is more beneficial for CDS indices which is driven by the substantially lower volatility of CDS indices.