U.S. Credit Swap Trading Soars 80% as Debt Deadline Nears

Trading of credit-default swaps insuring U.S. Treasuries soared almost 80 percent as the deadline nears for plans to cut the nation’s budget deficit and raise the $14.3 trillion debt limit to avoid default.

Traders bought and sold 41 contracts in the week through July 22, insuring a daily average of $250 million of U.S. debt, up from $140 million during the past month, according to the Depository Trust & Clearing Corp. The country was the tenth most traded among the 1,000 entities tracked by DTCC, with 1,063 outstanding trades covering $4.9 billion of debt -- a third of the total on German bunds.

Failure by President Barack Obama and congressional leaders to reach a debt agreement may force the government to delay bond payments, causing a credit event that would trigger insurance payouts. The parties are struggling to reach a compromise before Aug. 2, the date Treasury Secretary Timothy F. Geithner said the government will run out of options.

“While investors remain hopeful that the debt ceiling will be raised prior to Aug. 2, it is still unclear if such a move will be accompanied by a deficit reduction package that will be large enough to placate the ratings agencies,” Barclays Capital strategists led by Bradley Rogoff in New York wrote in a note to investors.

Treasury Yields

For all the concern about a default, yields on the benchmark 10-year Treasury note are about 3 percent, below the average of 4.05 percent over the last decade and less than the average of 5.48 percent when the U.S. was running budget surpluses between 1998 and 2001.

The U.S. determinations committee of the International Swaps & Derivatives Association may call a failure-to-pay credit event after a three-day grace period, said David Geen, general counsel for ISDA. The industry group sets standards in the swaps market and runs the committee of dealers and investors that determine when payouts are made.

A technical default would allow swap buyers to be compensated even if the debt commitments are eventually honored.

“For CDS, if it triggers it triggers,” London-based Geen said in an interview today. “If they fail to make a payment and the grace period passes, even if they cure it the next day, it still triggers.”

Debt Auction

That would cause an auction to settle swaps based on the value of the cheapest securities available. While U.S. Treasury debt typically trades at or above par, some longer-dated bonds are quoted below face value.

The government’s $25.9 billion of bonds due in February 2039 traded at 87 percent of face value, meaning swaps buyers would be paid 13 percent to settle the contracts.

“Even under a scenario of failure to raise the debt ceiling, we view default a lower likelihood outcome relative to payment prioritization,” Jeffrey Rosenberg, a credit strategist at Bank of America Merrill Lynch in New York, wrote in a note to investors. “Such an outcome however implies a government shutdown and the negative economic consequences of this would weigh negatively on credit spreads, albeit less than that under the dire version of the ‘default’ scenario.”

While credit swaps signal less than a 2 percent chance the government will default within the next year, the insurance contracts are the most expensive they’ve ever been. Swaps insuring Treasuries for one year cost a record 80 basis points yesterday, according to CMA, up from 46 basis points last week and 23 at the start of the year.

One-year contracts surpassed longer-term insurance for the first time this week and are now more expensive than Saudi Arabia, Belgium, Turkey and Thailand, CMA prices show.

Five-Year Swaps

Five-years contracts are trading at 63.5 basis points, the highest level since March 2009, and signal a 5 percent chance of default within that time, according to CMA. That compares with 37 basis points in April and a record 100 basis points at the peak of the financial crisis in 2009.

Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

“If CDS is triggered, you’d get paid out but then your protection is gone,” ISDA’s Geen said. “Your protection would effectively be knocked out and settled and if you had to re-hedge, it could cost more.”

Notional Value

Swaps on U.S. debt are relatively new, having only been tracked by CMA since 2007, when they cost less than 10 basis points a year. Trading is still low compared with outstanding securities. While the notional value of protection has increased 57 percent this year, the amount is only 0.05 percent of total marketable U.S. public debt.

Swaps on the U.S. also cover a fraction of contracts on European governments. Italy has $25 billion of swaps outstanding, the most in the world, followed by France with $21 billion and Spain with $18 billion. Swaps on Germany cover $16.5 billion and the U.K.’s protect $12.3 billion.

“I always thought buying CDS protection on the U.S. was a complete waste of money because if the U.S. defaulted, you’d never find a counterparty who would pay you,” said Gary Jenkins, head of fixed income at Evolution Securities in London. “However I was wrong, because this is the one scenario where you should definitely be paid out.”