US Sovereign CDS Will Track Sentiment About the Debt Ceiling Outlook

Summary

• The media, if not markets, has realised the debt ceiling crisis may go to the wire.
• We review the sovereign CDS market and how US CDS will work should the unthinkable happen.
• The 2011 debt ceiling crisis seemed to spark some counterintuitive market moves, especially after its resolution, but these were more related to the rising European sovereign debt crisis.

Market Implications

• If the debt ceiling deadline approaches with no resolution in sight, we recommend investors prepare to hedge against a significant selloff in equities and bonds.
• Banks could be particularly vulnerable given their reliance on implicit government support and large holdings of Treasury securities.
• Buy index puts; short index ETFs for equities, Treasuries and corporate bonds; buy protection on investment-grade and high-yield CDS indices.

Another year, another Congress, another debt ceiling crisis. Usually, these things get resolved after tense negotiations and much noisy posturing. But as we learned in July 2011, they can go right to the brink of default too.

Consensus believes this crisis will also see resolution – if only because the consequences of the US defaulting on US debt are unthinkable. Since Republicans have refused to help Democrats pass debt ceiling legislation, Democrats must pass it through the reconciliation process. Rather than the usual 60-vote supermajority, the process allows a simple majority vote to approve budget- and debt-related legislation.[1] The consensus is counting on Democrats being the adults in the room.

As we wrote earlier this week, progressive Democrats have a huge stake in how this is done. If their $3.5tn social and infrastructure bill must be sacrificed to raise the debt ceiling, it will take only one of them to refuse to be an adult to precipitate crisis – unless Republicans break ranks. That is not our base case, but given how polarized US politics have become, it is possible.

US Sovereign CDS Come to Life

This potential drama has raised questions about a normally comatose corner of the market: credit default swaps on US Treasury debt. Yes, they exist, but in minuscule amounts relative to the $28tn of outstanding debt. Over the past year, five-year default swaps have traded in a narrow range around 9bp; in recent days, it has gapped out to 13bp. We expect it will keep leaking wider, especially if the debt ceiling deadline goes down to the wire with no resolution in sight.

What Happens With CDS if the Unthinkable Happens?

An outright failure to pay a scheduled interest or principal obligation triggers the CDS, with the proviso that there is a three-day grace period to cure the default. Importantly, the default applies not just to the security where the failure to pay occurred but extends to all securities that rank pari-passu with the defaulted security. 

Once the grace period expires, the CDS contract can be settled by either delivering defaulted securities to protection sellers for par, or through a cash settlement process. In the latter case, an auction process sets a market price for defaulted Treasuries, and protection buyers receive the difference between par and the auction price.

Note that no standard payout exists for a credit default swap. The payout depends on the difference between par and the recovery value, or market value of the security after default. If the default were viewed as largely technical and defaulted Treasuries traded at 95 cents on the dollar, the payout would be 5%. On the other hand, the potential floor for recovery is zero! It will depend on facts and circumstances at the time of default.

Down to the Wire in 2011

The last time the US came close to default due to the debt ceiling was in the summer of 2011. Congress failed to raise the debt limit several times earlier in the year. In late July, the Treasury said it would run out of money around 2 August. Congressional Republicans were locked in negotiations with the Obama administration over spending cuts as a condition of raising the debt ceiling. When talks stalled on 27 July, the S&P 500 sold off by a sharp 1.6% after having exhibited little concern in preceding weeks – it had seemed inconceivable that Congress would fail to reach a deal (Chart 1). Treasuries were little changed.

On 31 July (a Sunday), a deal was announced and approved.

Over the next two weeks, equities sold off and Treasuries rallied. On 8 August, S&P downgraded the US to AA+, and the S&P 500 dropped 6.6%. The next day, the 10-year Treasury yield fell a counterintuitive 22bp.

The complicating factor in early August was that the European sovereign debt crisis was heating up, spurring a flight to quality into Treasuries and contributing to the equity selloff. Teasing out how much of these market moves were due to the post-debt ceiling crisis and how much to developments in Europe is all but impossible.

The Takeaway for Today

Our best guess now is that markets will again largely refrain from pricing in some risk of a debt ceiling crisis simply because it seems inconceivable that Congress would go that far. Yet as 2011 showed, it can be willing to get a long way down the road before doing something. And Congress today is even more polarized and unwilling to cross party lines when partisan ‘principles’ are at stake. For that reason, equity markets will be more watchful this time. If no resolution appears in the works, they will not let things go as long as they did in 2011 before selling off.

Treasuries are a more open question. If a default happens, our best guess is that they would sell off sharply, especially once the grace period expires. The extent of the selloff will depend on the facts and circumstances at the time.

In the corporate sector, bank bonds and CDS will be vulnerable to a significant selloff. Banks have significant holdings of Treasury securities and depend on implicit government backing.

Nonfinancial corporate spreads will come under pressure as equity volatility rises. Whether this is temporary or more systemic will depend on whether markets anticipate a deep recession after a default.

We recommend investors prepare to do the following if a deadline approaches with no clear resolution:

• Buy equity index puts.
• Short index ETFs for equities, Treasuries, and corporate bonds.
• Buy protection on the investment-grade and high-yield CDX indices.

[1] Normally in the Senate, final legislation goes through a two-step process. First, 60 votes are required to end debate on a bill. It then goes to the floor for a final vote, where only a simple majority is required. An inability to summon 60 votes to end debate (also known as a filibuster) effectively dooms the legislation even if a majority support it. For budget- and debt-related legislation, there is the reconciliation process, where the debate vote is bypassed, and legislation can pass with a simple majority. The catch is it can only be used once a year.