Treasury Securities and the U.S. Sovereign Credit Default Swap Market [July 25, 2011] [open pdf - 405KB]
"Paying the public debt is a central constitutional responsibility of Congress (Article I, Section 8). U.S. Treasury securities, which represent nearly all federal debt, have long been considered riskfree assets. The size of federal deficits and the projected imbalance between federal revenues and outlays, however, has raised concerns among some. Uncertainties surrounding the debt limit have raised issues related to a hypothetical federal default. Prices for Treasury securities suggest that financial markets consider a federal default unlikely, although credit rating agencies warned of possible downgrades, which could raise borrowing costs and negatively affect capital markets. A typical credit default swap (CDS) contract specifies that a CDS holder, in exchange for an annual fee set by the market and paid quarterly, can trade an asset issued by a 'reference entity' for its par value if a 'credit event' occurs. […] This report explains how the sovereign CDS market works and how such CDS price trends may illuminate fiscal stresses facing sovereign governments. Although CDS prices may be imperfect measures of the federal government's fiscal condition, some investors may try to glean information from those price trends. CDS prices have been playing an important role in the European government debt markets and could potentially affect U.S debt markets in the future. European policymakers have debated certain restrictions on types of sovereign CDS trading, and such calls for reform may be of interest to U.S. lawmakers. This report will be updated as events warrant."
CRS Report for Congress, R41932