From the Mailbag: CDS Spreads and the Debt Ceiling

After our recent article about Treasury bill auction results suggesting markets see next to no chance of a debt ceiling-induced default this summer, a couple of readers sent us a good question—one we think all of our readers would benefit from walking through. As some outlets have noted, US Treasury 1-year credit default swap (CDS) costs are up since mid-January, when debt-ceiling talk started perking. These contracts are essentially insurance against default. So why would people pony up the premium for something so unlikely to happen? Why indeed! We think it is likely a combo of two things: investors hedging for a verrrrrrrrrrrrrryyyyyyyyyyy unlikely risk and traders making an ultra long-shot play that requires little principal down for a big payoff in the very unlikely event that a default happens. This doesn’t appear to be mass movement, but rather a few players driving seemingly large moves in an illiquid, thinly traded market.

One-year CDS spreads (basically the insurance premium to insure a 1-year Treasury bill) are up from less than 20 basis points (bps, or hundredths of a percentage point) in late 2022 to a smidge over 70.^[i] This means that where it cost just under $20 to insure $10,000 worth of T-bills in 2022, it now costs about $70—on paper, a seeming indication of significantly higher default risk. But thinking of it this way essentially zooms in on a very small move. To get a better sense of default risk, we think it makes more sense to compare these costs to CDS spreads surrounding an actual default—or a scenario when it was a realistic probability.

For that, look to Greece. In late 2015, when a leftist government was on the verge of taking power and Grexit was once again on the table, Greek CDS spreads spiked over 1,000 bps.^[ii] In September 2011—a few months before Greece defaulted and just before its CDSs stopped trading—the eurozone’s distressed nations’ collective CDS spreads topped 1,400 bps.^[iii] Core eurozone nations’ collective CDS spreads also rose—but to just over 200 by 2011’s end.^[iv] It was a large move, more than double 2010 levels, but the level was ultra-low relative to the periphery and, crucially, no one thought Germany, France, Austria and all the rest were going to default at the time. And they didn’t.

Back then, it was a matter of investors paying a nominal fee to hedge for a very distant probability—similar to what some are doing with Treasury bills now. In a market as thinly traded as US Treasury CDSs, it doesn’t take much to move the price a bunch in either direction. The fact that people are hedging seems more like a normal behavioral reaction to increased default chatter—a sentiment indicator—than something assigning a probability. We also suspect there is some speculation going on—traders doing fancy trader things. Those speculating on CDSs are paying about 70 cents to get $1 back if the Treasury misses a bond payment and the CDS payout triggers. It is a trade that is more about possibilities than probabilities, and the people making them probably run a big fund with all sorts of positions, some speculative, in hopes that one or three actually work. Some not. 

Either way, a CDS spread of 70 bps in a thinly traded market doesn’t imply a vastly increased likelihood of default, in our view. Rather, it seems to us like a simple case of headline chatter driving some short-term volatility.