Treasury Securities and the U.S. Sovereign Credit Default Swap Market

D. Andrew Austin
Analyst in Economic Policy

Rena S. Miller
Analyst in Financial Economics

Paying the public debt is a central constitutional responsibility of Congress (Article I, Section 8). U.S. Treasury securities, which represent nearly all federal debt, have long been considered riskfree assets. The size of federal deficits and the projected imbalance between federal revenues and outlays, however, has raised concerns among some. Uncertainties surrounding the debt limit have raised issues related to a hypothetical federal default. Prices for Treasury securities suggest that financial markets consider a federal default unlikely, although credit rating agencies warned of possible downgrades, which could raise borrowing costs and negatively affect capital markets.

A typical credit default swap (CDS) contract specifies that a CDS holder, in exchange for an annual fee set by the market and paid quarterly, can trade an asset issued by a “reference entity” for its par value if a “credit event” occurs. Par, or face, value is the value of a bond at maturity. A corporation or a sovereign government could be a reference entity. A committee of the derivatives trade organization, the International Swaps and Derivatives Association (ISDA), determines if a credit event has occurred, according to their interpretation of applicable guidelines. In general, failure to make a timely payment usually constitutes a credit event.

The cost of buying CDS protection on federal debt for a one-year duration has roughly doubled since the start of 2011. U.S. CDS prices are currently about 54 basis points (one-hundredths of a percent)—slightly lower than for Germany—but much lower than the cost of CDS protection for Greece, Portugal, and Ireland. A CDS contract covering $1,000 of federal debt at a price of 54 basis points (bps) would require annual payment of $54.

Some financial market and federal budget analysts view price trends for CDSs for U.S. debt as an indicator of the market-perceived risks of a default by the federal government. Although CDS prices reflect market assessments of default probabilities, the market for U.S. CDSs is small and thinly traded, which may limit its reliability as a measure of the federal government’s fiscal condition. The notional value of U.S. CDSs is only about 0.5% of publicly held federal debt according to available data sources. In a small and thinly traded market, a few large trades could strongly affect prices.

CDSs may provide a more useful indicator of sovereign default risks for countries with more immediate fiscal challenges, such as Greece and Portugal, where sovereign default risks may be more salient due to higher levels of fiscal stress; or for larger European economies such as Italy and Spain, which have recently come under increased fiscal stress. A sovereign default occurs when a sovereign government is unable to meet its financial obligations. The fiscal situations of several European Union member states, including Greece, Portugal, and Ireland, have raised concerns of policymakers, financial institutions, and investors about wider economic, financial, and political consequences.

This report explains how the sovereign CDS market works and how such CDS price trends may illuminate fiscal stresses facing sovereign governments. Although CDS prices may be imperfect measures of the federal government’s fiscal condition, some investors may try to glean information from those price trends. CDS prices have been playing an important role in the European government debt markets and could potentially affect U.S debt markets in the future. European policymakers have debated certain restrictions on types of sovereign CDS trading, and such calls for reform may be of interest to U.S. lawmakers.


Date of Report: July 25, 2011
Number of Pages: 22
Order Number: R41932
Price: $29.95

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