Yu, Fan, "How Profitable Is Capital Structure Arbitrage?", Financial Analysts Journal, Vol. 62, No. 5, (September/October 2006), pp. 47-62.
Abstract: This paper examines the risk and return of the so-called "capital structure arbitrage," which exploits the mispricing between a company's credit default swap (CDS) spread and equity price. Using an industry benchmark model called "CreditGrades," I implement a convergence-type trading strategy with 135,759 daily CDS spreads on 261 obligors. At the level of individual trades, substantial losses can occur as a result of the low correlation between the CDS spread and the equity price. However, an equally-weighted portfolio of all trades produces Sharpe ratios similar to those of other fixed-income arbitrage strategies and hedge fund industry benchmarks. In particular, the monthly excess returns on this portfolio are not significantly correlated with either equity or bond market factors.
Related reading: Valuation of Capital Structure using Simulation Techniques