The U.S. default trade returns

The U.S. has hit its debt limit, which means — given congressional dysfunction — that the chances of a sovereign debt default are real, if small. One consequence has been a spike in the price of credit default swaps (CDS) that pay out if the U.S. defaults.

Why it matters: The price action in U.S. sovereign CDS is important, but it can't be used in the same way that other CDS prices can, to infer a probability of default.

How it works: Think of CDS as insurance against a bond defaulting. The seller of a CDS contract is effectively taking on the risk that a certain borrower — like the U.S. governmentmight default. Buyers of CDS are seeking to hedge that risk.

  • In an event of default, the buyer gets 100 cents on the dollar, while the seller receives bonds from the issuer that have a face value of 100 cents — though the market value could be much lower. (In reality, there's an auction mechanism where the seller just ends up paying the buyer the difference between the two prices.)

By the numbers: U.S. CDS hit an all-time high of 83 basis points on Wednesday — meaning it costs $83 to insure $10,000 of Treasury bonds against the risk of default.

  • That's higher than the previous record high of 82 basis points set on July 28, 2011, during that debt-ceiling crisis.
  • During the 2013 crisis, the contract only rose as high as 63bp.
  • 34 of the 40 highest-ever levels for the contract have been seen just in 2023 so far, with many more sure to come.

Context: If the U.S. Treasury finds itself unable to pay all its bills as they come due, all manner of horrible things would probably happen, both in markets and in the economy as a whole.

  • It's a reasonable assumption, whether or not the government managed to continue to make payments on Treasury securities, that markets would fall precipitously. After all, U.S. government spending is roughly $10 trillion per year, and if that fell sharply the economic repercussions would be enormous.

Between the lines: Traders are trying to hedge that risk — that’s what the rise in the price of U.S. CDS indicates.

  • If questions surrounding the full faith and credit of the United States cause markets to plunge, the price of U.S. CDS is almost certain to rise dramatically.
  • Buying cheap CDS that soar in value when a crisis hits is a well-worn playbook: Hedge fund manager Bill Ackman famously made billions doing exactly that in March 2020.

Be smart: The bet here is not, really, that a U.S. default will cause the CDS to be triggered and that there is a potentially large profit to be made when that happens.

  • When the CDS on Fannie Mae was triggered in 2008, for instance, the recovery value on the bonds was as high as 99.9%. The sellers of protection, therefore, had to pay a negligible amount to the buyers of CDS, many of whom ended up losing money.
  • People selling the CDS are making the reasonable bet that, ultimately, the recovery value of Treasury securities will be very close to 100 cents on the dollar — even if there is an event of default. Until then, they pocket the income the buyers pay them.
  • Buyers of the CDS, by contrast, are effectively trading tail risk. If you think tail risk is going to become increasingly salient as the so-called X date approaches, you might well trade that by buying CDS now.

The bottom line: U.S. Treasury securities are considered risk-free assets in the financial world — they're the bedrock on which almost everything else is constructed. The U.S. can always print the money it needs to repay its debts.

  • If for some short period it fails to do so, however, the resulting tremors could be large, and the price of insurance against that earthquake would spike.

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