Wednesday, October 09, 2013

US Default Swaps Trade Soars on Debt Fear

October 9, 2013 5:52 pm

US default swaps trade soars on debt fear

By Tracy Alloway and Vivianne Rodrigues in New York
Financial Times

Growing investor fears that Washington could miss a payment on its debt has led to a surge in activity in the once-sleepy market for derivatives that insure against a US default.

Average daily trading of credit default swaps (CDS), which give investors protection on US government debt, has jumped to €150m in the past week from about €1.6m in recent months, according to the trading desks of two major European banks.

With the government shutdown now in its second week and no sign of a deal before October 17 – the day the US Treasury has said it will run out of funds to meet its debt obligations – the surge in CDS trading is the latest evidence that stress is beginning to creep into markets.

For investors, buying CDS can either be an insurance policy on a country’s debt or a way of making a speculative bet on the market’s perception of the sovereign’s creditworthiness. Sellers of the CDS contracts have to compensate buyers of the derivatives when a credit event, such as a sovereign default, occurs.

The spike in trading activity is unusual for US sovereign CDS, which is traditionally a very thinly traded market. Traders often say that buying protection on the possibility of the US government restructuring or defaulting on its debt, is akin to buying insurance for the end of the world.

“It’s pretty incredible to see this market suddenly going from zero to 100 in just one week,” said one CDS trader.

The cost to insure €10m worth of US government bonds over one year using CDS contracts has jumped more than tenfold, from about €6,000 in recent months to €66,000 on Wednesday, according to prices from Markit, the data provider.

At the same time the dealer banks who make markets in CDS have sharply increased their activity in contracts on US government bonds, according to Markit.

Dealers have started providing price quotes on one-year US CDS for the first time in months and are now making 15 to 20 quotes per day. Price quotes for protecting US bonds over the course of five years, traditionally the more popular contract, have roughly doubled to as many as 50 a day.

“It can be an indicator that you’re seeing more interest in the market,” said Gavan Nolan, analyst at Markit. “We’ve seen quotes go up quite a bit over the last week.”

Market participants are still debating whether a technical default by the US government would actually trigger payouts on US CDS. Even if contracts are not triggered, investors can use the price movement in the CDS to offset, or hedge, the movement in their other assets, such as short-term US Treasuries.

On Wednesday, investors continued to sell off Treasury securities that they deem most vulnerable to a missed payment. The yield on the T-bill maturing on October 17 jumped to 38 basis points on Tuesday, up from less than zero in September.

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