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Wednesday, August 31, 2011

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, have raised concerns among some, including the rating agency Standard & Poor’s (S&P), which downgraded the U.S. sovereign credit rating from AAA to AA+ on August 5, 2011. S&P also cited “political brinksmanship” in debt ceiling negotiations as a factor, which raised the issue of a hypothetical federal default. Prices for Treasuries suggest that financial markets continue to consider federal debt instruments a safe haven despite the S&P downgrade. Continued concerns about rising federal debt and the ability of policymakers to reach solutions to fiscal challenges could raise borrowing costs and negatively affect capital markets.

A credit default swap (CDS) contract is a way to hedge or speculate on credit risk, including sovereign credit risk. A CDS protection buyer, in exchange for an annual fee set by the market and paid quarterly, can trade an asset issued by a “reference entity” (or a cash equivalent) for its face value if a “credit event” occurs. A CDS buyer need not own or borrow an asset issued by the reference entity, thus may hold a “naked CDS.” A committee of the derivatives trade organization, the International Swaps and Derivatives Association (ISDA), determines whether 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, as does a repudiation of debts, and in some cases, debt restructuring

Some view CDS price trends for U.S. debt as an indicator of the market’s perception of the federal government’s creditworthiness. The cost of buying CDS protection on federal debt for a one-year duration has roughly doubled since the start of 2011. In mid-August 2011, U.S. CDSs traded at about 55 basis points (bps; one-hundredths of 1%), after having risen to about 63 bps after the S&P downgrade. U.S. CDS trading volume rose and prices hit a record high of about 82 bps in the week before President Obama signed the Budget Control Act of 2011 (S. 365; P.L. 112- 25) on August 2, 2011. The act included provisions to raise the debt limit and reduce deficits.

U.S. CDSs have traded in the same price range as Germany, which is far below sovereign CDS prices for Greece, Portugal, and Ireland. For example, in mid-August 2011, Greek CDSs traded around 1700 bps, Portuguese CDSs around 800 bps, and Irish CDSs around 700 bps. While the federal government faces fiscal challenges, especially in the long term, markets seem to regard fiscal stresses confronting some European governments as far more severe and immediate.

The U.S. CDS market is small and thinly traded, which may limit its reliability as a measure of the federal government’s fiscal condition. CDSs may more usefully indicate 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. Four Eurozone countries imposed certain restrictions on types of sovereign CDS trading in August 2011. 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, which could potentially affect U.S. debt markets in the future. European calls for reform in sovereign CDS trading may also be of interest to U.S. lawmakers.

Date of Report: August
15, 2011
Number of Pages:
Order Number: R41
Price: $29.95

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