Credit Default Swaps, or CDS, are a type of security that provides protection against default on bonds. Investors are worried that the U.S. government may struggle to pay its debts — and are buying insurance to protect themselves in the event of a default.
The cost of insuring exposure to U.S. government debt has been rising steadily and is near its highest level in two years, according to LSEG data. The spread, or premium, on one-year U.S. credit default swaps (CDS) has risen to 52 basis points, up from 16 basis points at the start of the year, LSEG data showed.
What are CDSs?
CDSs are like insurance for investors. Buyers pay a premium to protect themselves in the event that the borrower — in this case, the U.S. government — defaults on its debt.
When the cost of insuring U.S. debt rises, it’s a sign that investors are worried. Spreads on five-year CDSs were nearly 50 basis points, up from about 30 basis points at the start of the year.
In a CDS contract, the buyer pays a recurring premium, called a spread, to the seller. If the borrower, in this case, the U.S. government, defaults on its debt, the seller must compensate the buyer.
CDSs reflect how risky a borrower appears to be and are used to protect investors from signs of financial trouble, not just a full-blown default, Trust Economics reports.
What are markets pricing in?
The recent surge in demand for CDS contracts is “political risk insurance, not insolvency,” highlighting broader concerns about U.S. fiscal policy and “political dysfunction,” rather than a market assessment that the government is close to defaulting.
Investors are pricing in growing concerns over the unresolved debt ceiling dispute.
Credit default swaps have become popular again as the debt ceiling remains unresolved and the U.S. Treasury is set to hit its legal debt limit in January 2025.
The Congressional Budget Office said in a March advisory that the Treasury had already reached its current debt limit of $36.1 trillion and had no room to borrow, “except to replace maturing debt.”
Treasury Secretary Scott Bessent said earlier this month that his department was calculating tax revenues collected around the tax filing deadline (April 15) to come up with a more accurate forecast for the so-called “X-date,” when the U.S. government will run out of borrowing capacity.
CDS spreads on US government debt typically coincide with periods of heightened concerns about the debt ceiling, particularly in 2011, 2013 and 2023.
In the past, the US has come dangerously close to defaulting, but in each case, Congress acted at the last minute to raise or suspend the debt ceiling.
Fiscal Valuation
The rise in CDS prices is likely to be a “short-term” reaction as investors wait for a new budget deal to raise the debt ceiling.
It is unlikely to be a sign of an impending financial crisis. During the 2008 financial crisis, institutions and investors actively traded CDSs linked to mortgage-backed securities, many of which involved high-risk prospective borrowers.
When mortgage defaults increased, these securities collapsed in value, resulting in huge CDS payment obligations.
However, the implications for increased demand for sovereign CDSs are very different compared to demand for corporate CDSs, as was the case in 2008, where investors made a real assessment of the increasing risk of corporate defaults.
