What the Credit-Default Swaps Market Reveals

It costs more to buy insurance against the default of France or Germany than the United States.

By + More

While stocks experienced a massive selloff on Monday, the U.S. treasury market saw an influx of investors even as Standard & Poor's issued its first-ever downgrade of U.S. government debt. Investors still have faith in the issuing power of the United States government, which has some experts wondering if S&P's downgrade was taken seriously by the markets. For a more accurate, real-time assessment of the credibility of governments and companies throughout the world, investors can watch trading in credit default swaps, or CDSs, where investors buy and sell securities designed as insurance against an issuer defaulting on its debt.

The higher price of the swap the more risk the market is assigning to that particular issuer. Investors watch CDS prices to assess the risk of investing in different securities, whether it's governments or individual companies.

[See 50 Best Funds for the Everyday Investor.]

The CDS market revealed an interesting trend on Monday. The cost to buy five-year insurance—the most commonly cited type of swaps—on debt issued by the U.S. government didn't change following S&P's downgrade on Friday, according to data-provider Markit. "The CDS market has anticipated the downgrade for a bit of time," says Otis Casey, director of credit research at Markit in New York. "Much of the market reaction [on Monday] has been in equities."

The Dow Jones Industrial Average plunged more than 600 points on Monday, its sixth-worst loss ever. Casey says the selloff is only partially a reaction to S&P's downgrade. Instead, he attributes the bulk of the selling to rising concerns about a double-dip recession in the United States and renewed worries that the European sovereign debt crisis is spreading to larger countries such as Spain and Italy.

[See What a Ratings Downgrade Would Mean for Investors.]

In fact, the CDS market still seems to be saying U.S. bonds are among the safest in the world. Interestingly, even after the United States has lost its top-notch rating, it's still cheaper to buy insurance against the default of the U.S. government than other AAA-rated countries in Europe. Five-year insurance for U.S. CDS trades at 57 basis points, a level that Casey says is generally associated with countries that are rated AA. Even so, prices on AAA-rated debt abroad are higher. It's currently more expensive to buy five-year swaps on government debt issued by France, Germany, and the UK, all of which are still AAA-rated by S&P.

On Monday, France's CDS levels widened by 14 basis points—a huge jump in CDS market terms—and it now trades at 160 basis points. German and UK CDS levels now trade at 74 basis points and 80 basis points, respectively. A spike in French swaps, in particular, has some market watchers worried that France may soon be engulfed in the European sovereign debt crisis. "French CDS levels are trading with an implied rating more along a single-A range," Casey says. That means investors are much more worried about the safety of French bonds than bonds issued by the U.S. government. In other words, the market is saying that as bad as the American economy looks, much of Europe is even worse.

The performance of U.S. treasuries after the downgrade support that notion. Talk of a global economic slowdown has investors scooping up treasuries issued by the newly-downgraded U.S. government. The rush to assets still seen as a safe-have has pushed the 10-year treasury yield—seen as a benchmark for the entire bond market—to 2.3 percent, its lowest level since January 2009.

[See Is Germany the New Safe Haven?]

That's driven some market watchers to place a greater emphasis on an issuer's CDS level rather than the rating assigned to it by an agency like S&P. "[The CDS market] is more real-time, and it's based on the consensus in the marketplace as opposed to a set of analysts cloistered away at a ratings agency," Casey says. "Increasingly, people are looking at the CDS market as another data point to weigh in on the creditworthiness of a particular issuer."