U.S. Sovereign Default Swaps Jump as Debt Ceiling Deadline Looms

Credit-default swaps insuring against losses on U.S. Treasuries almost doubled this week as the deadline for raising the nation’s $16.7 trillion debt limit approaches.

The cost of one-year contracts jumped to 62 basis points from 33 basis points, according to date provider CMA, with the four-day partial government shutdown showing no sign of ending. President Barack Obama canceled plans to attend two economic summits in Asia amid wrangling by U.S. lawmakers over the budget and Oct. 17 debt ceiling.

“The probability of default will increase in everyone’s minds as we go through next week,” said Luke Hickmore, an Edinburgh-based investment director at Scottish Widows Investment Partnership, which holds about 30 billion pounds ($48 billion) of corporate debt. “We could be in for a rocky ride if we don’t get an agreement at the weekend.”

Hickmore said he’s buying 10-year Treasuries and selling two-year securities as well as using the Markit iTraxx Crossover Index of credit-default swaps on 50 companies with mostly high-yield ratings to hedge against price swings.

Royal Bank of Scotland Group Plc is also recommending using the Markit benchmark to buy protection against volatility. The Crossover index was little changed this week at 397 basis points, according to data compiled by Bloomberg.

Volatility Trades

“Those volatility reduction trades are worth doing as we get nearer the potential deadline,” Hickmore said. “If a default doesn’t happen they’re easy and cheap to take off again. People will be increasingly doing this as the shutdown wears on.”

Two-year credit-default swaps contracts rose to 46.5 basis points from 31, while 10-year swaps fell to 46 from 51 as the chances of an imminent payout increases.

Trade volumes are also climbing, with swaps on Treasuries the 15th most active of 1,000 entities tracked by the Depository Trust & Clearing Corp. in the week through Sept. 27, up from 147th the previous period. There were 56 trades covering a gross $2.1 billion of Treasuries, compared with 10 trades covering $290 million the previous week, according to DTCC, which runs a central registry for the market.

There are now 886 contracts covering a net $3.4 billion of debt outstanding, the most since March and up from an almost three-year low of $3.1 billion on Sept. 20. The 8 percent increase is the biggest since June 2011.

That compares with $13.1 billion of protection on German bunds and $16.9 billion on Italy’s debt.

“Even though it remains an unlikely scenario, we believe credit markets are being complacent about political risks,” said Alberto Gallo, an analyst at RBS in London. “While we remain structurally long European credit, financials, high yield and the periphery, we think October could see volatility rising and maintain our hedge on iTraxx Crossover.”

Before it's here, it's on the Bloomberg Terminal.