Will U.S. Default? $4.8 Billion Investment Says Yes

July 27, 2011 -- Investors are spending $4.8 billion to hedge against the possibility that credit rating agencies will downgrade U.S. debt--or worse, that the U.S. actually will default. Doomsayers predict these and other dire consequences if Congress fails to act by August 2 to raise the nation's debt ceiling.

Rating agency Standard & Poor's earlier in July warned the U.S. that it risks a downgrade of its top AAA rating to AA status, unless Congress lifts the $14.3 trillion ceiling and reduces total debt by $4 trillion over 10 years. The agency in April lowered its rating outlook for the U.S. from stable to negative.

Investors worried at the prospect of a U.S. downgrade or default could protect themselves several ways, say experts. Joe Magyer, senior analyst at the Motley Fool, says an investor could, for example, go entirely to cash. Otis C. Casey, director of credit research for Markit, a financial information services company, says an investor could unload any U.S. debt he might own, such as bonds, and move into some other safe-haven asset, such as gold, whose price has recently hit record highs on fears over the debt fight.

A person also could invest in a mutual fund whose return goes up when U.S. treasuries go down. Such funds allow investors, in effect, to bet against U.S. debt. Examples include the ProShares Trust Ultrashort 20+ Year Treasury EFT and the Rydex Inverse Government Long Bond Fund.

Big institutions and the most sophisticated investors use credit-default swaps (CDS), which act like insurance policies against the deterioration of debt, be it corporate or the debt of a sovereign nation. If the debt is downgraded or if the borrower defaults, a swap makes the debt-holder whole again.

The amount of money in U.S. credit-default swaps increased 57 percent this year to $4.8 billion, according to the Depository Trust & Clearing Corp, which provides clearing, settlement and information services.

Any increase in the price of a swap is a sign of investors' declining confidence in the soundness of the underlying debt. Casey, for that reason, calls swaps early-warning indicators. As Congress has continued to wrestle over raising the debt ceiling, the price of U.S. swaps has risen.

As recently as May 17, when debt negotiations between the bipartisan so-called "Gang of Six" broke down, the spread of U.S. swaps stood at 41 basis points. (The figure refers to the cost of insuring $10 million of U.S. debt for five years, which, as of the May date, was $41,000.) Since then, it has climbed into the 50s. Today it hit 63--the highest price since February 8, 2010.

"It spiked Monday," says Casey, who attributes the rise to investors' jitters over the August 2 deadline. "It's been very sensitive to the twists and turns of the policy debate—more so than any other metric."

Kevin McPartland, director of fixed income research at the TABB Group, a market research and advisory firm, says, "the current price is an indication of the market's expectation that U.S. debt will experience some kind of 'credit event'—such as a downgrade."

As worrisome as the current price may be, it's nothing compared to prices on the CDS of countries in the Eurozone. Says Casey, "Looking at all the different sovereign debt, the number for the U.S. is vastly lower than what we see for troubled Eurozone peripherals."

According to data provider CMA, swaps on Greece's debt stand at 2,500. That means to insure against a default on $10 million worth of Greek debt, you'd need to put up $2.5 million. Portugal's spread is 952; and Spain's, 337. In fact U.S. swaps are cheaper than those for 53 of the 58 countries CMA tracks.

Suppose that August 2 arrives, and that Congress fails to act. What happens then to holders of U.S. debt?

"Some people have speculated," says Casey, "that there are so few safe havens for investors that U.S. bonds might actually benefit if the debt ceiling isn't raised." Panicky investors, in other words, might flock to U.S. treasuries as their least-bad option. "That," says Casey, "would be the ultimate irony."