Is the Market Expecting a Debt Default?

July 14, 2011 | Nat Kellogg, CFA, President, Director of Manager Search

With the August 2nd deadline fast approaching investors are increasingly wondering whether the U.S. might actually default on its debt obligations. In an effort to gain some insight into what the market is expecting, this chart looks at the pricing of Credit Default Swaps (CDS) on U.S. Government debt over the last year. CDS only pay off in the event of a default and are often used by bondholders to hedge against the risk that a bond in their portfolios defaults. As a result rising CDS prices offer a good indication that the market expects a higher probability of default. What is most notable is the jump in CDS prices on 1 Year Treasuries, while at the same time, CDS on 5 and 10 Year Treasuries remain largely unchanged. Given the jump in CDS on shorter duration Treasuries the market seems to be indicating that, if there is a default, it is likely to occur in the next year. However, the lack of movement in CDS prices for 5 and 10 Year Treasuries indicates that the markets are assigning little overall risk of a default (because if a default occurred all Treasury bonds would suffer losses so we would expect to see a jump in spreads for CDS of all maturities). Lastly, to put these numbers in perspective, CDS on 5 year Greek debt trades at 2,320, CDS on 5 year French debt trades at 107, and United Kingdom debt trades at 75. So while there is considerable amount of concern over the debt ceiling deadline in Washington, the markets appear to be pricing in little risk of default.