US Treasury Default Risk Now The Same As JCPenney's Was In July

The cost of protecting against a default on US Treasuries for one-year has surged to 60bps this morning. This is the highest since the Debt-ceiling debacle in 2011 and worse than Lehman. The 1Y cost is the highest relative to the 5Y cost ever.


However, many people look at the 60bps and shrug it off as de minimus, after-all, JCPenney trades at 1200bps-plus and is still alive. This is a mistake.


The price of protection for US sovereign debt depends on recovery expectations AND the EURUSD exchange rate expectations. Based on current levels, USA CDS imply a 5.9% probability of default – the same as JCPenney in July.

When an entity defaults, the CDS is triggered and an auction takes place to settle the transaction… the buyer of insurance delivers a bond and the seller of protection delivers “par” or 100 cents on the dollar. Therefore the buyer of protection pockets the difference between the cheapest-to-deliver bond and 100.

In the case of US Treasuries, the cheapest to deliver bond is a longer-dated bond trading around $84 (and so that will be in big demand should a technical default occur as protection buyers scramble to lock in their profit.)


Also, given that the current premium is 60bps (and it trades in EUR since there would be no protection in USD as the US government could simply print more money to pay its debt and the owner of debt would be unprotected from wealth destruction), which is around 80bps in USD, a recovery of 84c implied a 5.9% chance of US Treasury technical default over the next year.


In the case of JCPenney, assuming the standard 40% recovery (which could be worse given Goldman’s 1st lien), the US Treasury default rate of 5.9% implies a spread of around 300bps for JCPenney – a level which it was at in July.

The bottom line is that considering 60bps as a small number is a mistake and we hope we have clarified a little about just how concerned investors should be at these levels in this arcane marketplace.

(Note: bear in mind there are a miriad of additional technical details that complicate this analysis further but we hope this gives a sense of the relative scale of a 60bps level for 1Y USA default protection).


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