IFR-US CREDIT-Debt worry draws speculators to US CDS

by Kathleen Hoffelder

NEW YORK, June 3 (IFR) - The credit default swap market
referenced to the US government was always something of a
backwater. After all, the chances of a default had long seemed
very low.

But with US debt now at stratospheric levels and the
Republican-controlled House refusing to allow the so-called
debt ceiling to be raised, attention is now being paid to whole
parts of the US sovereign CDS curve as hedge funds place bets
on every word out of Washington.

Sovereign US CDS was barely considered by active traders as
a means to participate in the sovereign CDS market. Indeed,
even amid the debt crisis in October 2009, CDS on sovereign US
was only in the low 20bp range compared with more than double
that now. Latin American names and the so-called PIGS --
Portugal, Ireland, Greece and Spain -- were where the action
was.

But in recent months that has all changed. The US reached
its US$14.3trn debt ceiling on May 16 and since then the
Republican-controlled House of Representatives has rejected a
proposed US$2.4trn increase in the debt cap because it did not
also offer spending cuts.

The result was a golden opportunity for hedge funds, major
participants in the market. Speculators put on positions on US
CDS -- not in the belief that the US would default, but to
trade how soon a resolution could come to pass.

"Since this debt ceiling news, we've seen a lot more
activity on [US] CDS," said one sovereign CDS trader. "We've
seen some participants trying to put on curve trades, mostly on
the flattening side," he added.

Although the US will not officially breach its debt ceiling
until August 2, few industry participants expect a technical
default -- whereby the US would not make its coupon payments- -
to actually take place.

That means the US CDS is less a measurement of true default
fears than a tool to speculate on them.

"No one believes they are not going to come to a
resolution," said Christian Cooper, head of US derivative
trading at Jefferies. "What's going to drive the market is the
unexpected surprise that may come out of the negotiation as we
get closer. What is the American brand of austerity going to
look like?"

HEDGING THEIR BETS

Two weeks ago, speculators were particularly active in
flattening the sovereign US CDS curve, which was led by the
front end.

"We've seen quite a few buyers of protection in very
short-dated protection from accounts playing a hedge, which
indicates [that they think that] the battle between the
President and the Congress [will go] a bit too far," said the
sovereign CDS trader.

Curve trades recently involved buying five-year CDS
protection and selling 10-year protection, and similarly buying
one-year CDS protection against selling five-year CDS. Even
six-month sovereign CDS has traded.

"Probably this issue will be solved in the next two months,
so if you buy six-month protection or one-year protection, even
if you pay 50bp, which is roughly flat to five-year CDS you
would have an amazing reward. You would make 20 points on your
nominal for very minimal cash invested," the trader said.

The data support the short-term plays. Last week, one-year
CDS was at 35/45bp, which is only a touch tighter than
five-year CDS at 50bp and close to 10-year CDS at 53/57bp.
Six-month CDS is trading on top of one-year CDS currently.

According to the Depository Trust & Clearing Corporation,
US sovereign CDS had US$26.1bn of gross notional outstanding at
the end of May.

For the past few months, sovereign CDS players have been
busy playing the headlines.

"When there was more Republican thunder mid-April, it
[10-year US CDS] widened to 75bp," said a risk manager at an
asset management company. "US CDS moved lower to 59bp before
widening to 69bp after the Druckenmiller [former Soros fund
manager Stanley Druckenmiller] comments [on May 14]."

Druckenmiller was quite vocal in press reports last month
about restraining US government spending, even if that meant
delayed coupon payments.

If the US government simply exceeds the debt limit,
however, it would not trigger the CDS, and if it missed a
coupon payment within the grace period there would also be no
trigger, added the sovereign trader.

The sovereign CDS world is, indeed, different from
corporate CDS, where failure to pay and bankruptcy would
constitute a credit event. In sovereign US, Western Europe,
Asia, Singapore and Japan CDS, only failure to pay would be
considered a credit event, according to a recent Morgan Stanley
analyst report.

For sovereigns in Latin America, Eastern Europe and the
Middle East, though, neither a failure to pay or bankruptcy
alone would trigger a credit event, the analysts said in their
report.

Even in the case of a default, deliverability is not the
same compared with other CDS. Sovereign CDS falls under the old
restructuring rules as well -- whereby all qualifying bonds of
less than 30 years are deliverable into all sovereign CDS.

But even if a technical default were to occur for the US,
market participants say, such a default would be brief at best.
After all, the US has many things going for it. The US dollar
is still the world's reserve currency. If that were to change,
one interest rate strategist said he might consider a more
sombre outlook for the US, but for now, he prefers to wait out
the policymaking.

Ron D'Vari, CEO and co-founder of NewOak Capital, agreed,
saying: "It very much comes down to a power play between the
parties. Last minute, whoever brings the government down is not
going to survive the next election."

It remains uncertain whether the governmental
powers-that-be are indeed paying attention to the CDS market.
But according to the trader, the speculation in sovereign CDS
should be an "incentive for them to behave and to find an
agreement to do the responsible thing".

(A version of this story will run in the June 4 issue of
International Financing Review, a Thomson Reuters publication)

(Kathleen Hoffelder is assistant US editor for IFR; Tel:
1-646-223-8703)