Investors protect against US default

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Traders and investors have stepped up purchases of insurance against a US sovereign debt default, amid heated political wrangling over raising the US debt ceiling.

The gross value of derivatives contracts that pay out in the event of a US default has doubled from year ago levels, according to the Depository Trust and Clearing Corporation, which collects data on global trading of credit default swaps (CDS).

It reached $24bn at the end of last week, up from $22.7bn a week earlier and much higher then the year ago level of slightly less than $12bn.

Traders would be on the hook for a maximum payout of $4bn in a default, once contracts are netted against each other, according to the DTCC.

“US CDS have seen a spike in activity and increase in interest from investors,” said George Concalves, head of US rates strategy at Nomura.

The size of the US sovereign credit derivatives market is still small relative to the amount of hedging and trading that takes place on eurozone sovereign debt.

For example, the current value of outstanding CDS on Greece is $78bn and CDS on Italy’s sovereign debt totals $284bn, DTCC data show. The US derivatives positions are dwarfed by the size of the US Treasury debt market, which adds up to about $9,500bn.

Nevertheless, the increased activity in derivatives highlights that at least some traders are assigning a probability – even though it is seen as remote – that the wrangling over the debt ceiling will not be resolved and that the US could then miss a payment on its debt. That could count as a technical default and may result in a payout on credit default swaps.

Congress has yet to approve an increase to the Treasury’s $14,300bn debt ceiling, with Republicans and Democrats embroiled in a fierce budget battle.

“[CDS trading is] all about the debt ceiling,” said David Ader, strategist at CRT Capital. “There is a risk that we get into August and the US could miss making a payment that nails investors.”

With trading in US sovereign CDS extremely limited, a low volume of activity can have a relatively large impact on prices.

One-year US CDS spreads have recently jumped on the back of a handful of trades. On May 20, the cost of protection for US sovereign credit jumped 22 basis points to 50bp. That was seen by traders as reflecting the need to cover the risk of Congress failing to pass the debt ceiling by August.

The price moves in derivatives markets have not been reflected in cash bond markets, where interest rates remain at historic lows. Investors were keen buyers of $35bn of five-year Treasury debt that was sold this week at the lowest yield levels of the year.

US benchmark Treasury yields were testing their recent lows on Thursday, ahead of a $29bn sale of new seven-year paper. The yield on 10-year notes was at 3.09 per cent, a key level that has held for the past month.

“Given the low yields across the US Treasury curve, it seems as if the cash bond market has paid little attention to the debt limit debate,” said Mr Concalves.

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