Along with the ability to buy auto insurance, life insurance and health insurance, the financial markets offer mechanisms to buy borrower default insurance.
The more commonly used tool is a Credit Default Swap, or CDS. Institutional investors can buy insurance against the possible default of borrowers such as the U.S. government.
Qualified market participants can buy or sell a CDS. A wide range of sovereign debt issuers can be insured, from the likes of Abu Dhabi, where a five-year CDS costs about $6,900 for every $1 million insured, to Vietnam, where a five-year CDS costs about $27,000 for every $1 million insured.
A similar five-year CDS for $1 million of coverage on U.S. government debt requires an upfront payment of about $2,430. Over the past year or so, the cost of similar sovereign default coverage for the U.S. government peaked at about $4,780 and has averaged about $3,770. The current CDS cost level is at the inexpensive end of the range, reflecting a relatively positive expectation for repaying debt obligations for at least the next five years.
An example of a country where Credit Default Swaps are trading at the expensive end of its one-year range is Cyprus. Not surprisingly, Cyprus has had challenges with the creditworthiness of its banking sector. A five-year CDS will cost about 13 percent of the insured value, or $130,000 for $1 million of sovereign protection. Over the past year, this same coverage for five years peaked at more than 15 percent.
Even with the continued economic malaise reported in much of Europe, many of the larger sovereign debt issuers are experiencing CDS levels at the cheaper end of the ranges observed during the past year. For example, a five-year CDS for $1 million of sovereign debt coverage for France will cost about $6,700, down from the high level for the past year of just more than $15,000.
Similar five-year default coverage for Germany’s government debt costs slightly more than $2,700 and has averaged about $4,000 over the past year.
Many factors affect the pricing of Credit Default Swaps for sovereign borrowers. To generalize, the premiums to hedge against default on issued debt reflect the average expectation at a particular time.
Assuming this explanation is a reasonable representation of CDS pricing, the markets are feeling relatively positive about the U.S. government's ability to meet its debt obligations. As debt ceiling negotiations heat up and borrowing limits are tested again, changes in CDS levels will imply this change in view of the U.S. government's ability to pay to meet its debt obligations.
Kirby Brown is the CEO of Beneficial Financial Group in Salt Lake City.
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