A measure of U.S. default risk is flashing red as talks over the government's debt ceiling drag on, with speculation driven by the lure of a quick profit inflating the value of the derivative, market strategists and investors said.
Spreads on U.S. government one-year credit default swaps – market-based gauges of the risk of a default - widened to 175 basis points, an all-time high, earlier in May on rising fears lawmakers could not reach a debt ceiling deal.
"The instruments are ... unusually attractive to buyers because the cost of the bonds that would be delivered into a default-triggered settlement auction have plunged in value over the last year," said Karl Schamotta, chief market strategist at Corpay, noting that it was due to the U.S. Federal Reserve raising rates.
The implied probability of a U.S. sovereign default - a measure of the probability using CDS spreads versus the value of the underlying bond - was still very low in the 3-4% area compared to the 6-7% area in 2011 during a similar legislative standoff on the same borrowing limit when CDS levels also spiked but only up to a high of 80 basis points, according to Reuters calculations.
“If the payout was just 5 times nobody would be doing it, but when you have 25 times payout, people want to bet on it,” said Daye.
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