CDS market shows U.S. risk-free status slipping

January 31, 2011

By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Betting on Treasury yields rising is one thing; trading the chance of default is another. U.S. credit default swap volumes have spiked in recent weeks. The CDS activity around Uncle Sam’s debt is still hardly mainstream. But unsustainable federal borrowing is tarnishing the debt market’s once pristine, risk-free benchmark.

Plenty of investors are concerned about the potential impact of the Federal Reserve’s monetary policies and inflationary pressures on Treasury bond yields. Unlike less liquid corporate bonds, though, there are already many very efficient ways to hedge against a rise in interest rates. Aside from possible arbitrage opportunities, what the CDS market adds is the ability to bet on an actual default by the U.S. government.

Treasury-related CDS contracts worth nearly $1.4 billion in total changed hands in the two weeks ended Jan. 21, according to the Depository Trust and Clearing Corporation — two-and-a-half times the average activity over the prior six months. Trading is still relatively thin. But the surge in activity points to an intensifying investor perception that the possibility of a U.S. government default can no longer be completely dismissed.

The price to protect against a Treasury default has been rising, too. It has reached $51,000 a year for five years for every $10 million of debt, around the highest price in nearly a year.

That’s still less even than protection against default by Germany, reflecting the fact that it’s still highly unlikely America will walk away from its debt, even temporarily. But a projected deficit of a whopping $1.5 trillion this year, a debt load held by the public that could double to $18 trillion in 10 years, and talk in Congress about a possible default if lawmakers can’t agree on an increase in the permitted maximum amount of debt have all made a default seem imaginable. That’s part of the eventual threat to the United States’ top credit rating recently highlighted by rating agency Moody’s Investors Service.

Debt market investors don’t, as yet, have an alternative yardstick for risk-free credit. And America’s obligations may yet recapture that unquestioned status. But CDS activity is one sign that the fallout of the financial crisis is gradually changing perceptions about U.S. creditworthiness — perhaps irreparably.

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