One of the more interesting things that I have noted in recent weeks is the dramatic disparity between the way that the media and politicians discuss the probability and potential fallout of the U.S. not raising the debt ceiling and/or defaulting on its obligations, and the way that the markets are reacting to the debate.
Just this morning (July 28), CNBC had the striking headline “If US Defaults, Stocks Fall 30%, GDP 5%: Credit Suisse.” That certainly sounds bad and it makes for a dramatic story. The story goes on to say that Credit Suisse sees a default as a low probability event, but also outlines a series of other lesser bad outcomes that may occur, such as the possibility that no budget deal is reached but the U.S. does not default (in which case they predict between a 10%-15% decline in stock prices).
Another great headline: “Default & Downgrade Doom: Options Traders Preparing for the Worst Says Najarian.” The quoted expert, Jon Najarian, is co-founder of OptionMonster.com. The final line of this article has the punchline:
The possibility that the world may be forced to acknowledge that the United States isn’t the safe haven it once was could be a wildly unpleasant shock to the entire financial system: as in bonds down, yields higher, stocks abused, and tsunami size ripples up and down the entire economy.
But What Does Mr. Market Say?
If investors held the consensus view that default was likely, they should be busy selling government bonds, thereby driving yields upwards. Is that happening? Nope. The yield on 10-year Treasuries is below 3%, which is far below the long-term average and near the minimums that we have seen for the past fifty years or so (see chart below).
Ten Year Treasury Yields (Source: Yahoo! Finance)
Treasury yields reflect two things: the market’s consensus view of the probability of an increase in real interest rates and inflation and the probability of a reduction in the credit worthiness of the issuer (the U.S. government, in this case).
At this particular point in U.S. history, the consensus view of bond holders is that there is remarkably little risk in U.S. Treasury bonds.
Let’s put the 2.95% yield on ten-year Treasuries into perspective. Italy just today issued 10-year bonds at a yield of 5.8%, an eleven-year high. Meanwhile, U.S. bonds are in the lowest range seen in the last fifty years. U.K. 10-year government bonds have a yield of 2.97%. German 10-year bonds are trading at a yield of 2.63%.
On the basis of yields, it can hardly be argued that the bond markets see much risk of a U.S. default.
Getting More Subtle
If you were really cagey and believed that there is a substantial probability of a default that will drive bond prices down and yields upwards, there is a very powerful way to create an investment that will be highly profitable. Rather than selling your government bonds or taking a short position in bonds, you would buy put options. This is a strategy that can be used to bet that bond prices will fall and yield will rise. I previously examined this strategy as the basis for providing protection against rising interest rates, but this approach may equally-well be applied to provide protection against a perceived increase in default risk by the U.S. government. Buying put options on government bond ETFs is the equivalent of buying ‘insurance’ against this possibility.
We can look at the prices of put options on government bond ETFs to see whether the put options are expensive, which would suggest that the options market is suggesting a substantial risk of a sell-off in government bonds and rising yields. The prices of options reflect the market’s assessment of risk and this is measured by what is called implied volatility—the risk implied by the options prices. As the market’s consensus view of risk goes up, options prices go up, and implied volatility also rises.
In the article I wrote in June 2010 on the prices of options on government bond ETFs, I recorded that put options expiring in January of 2012 on the iShares intermediate government bonds index (IEF) had implied volatility of 11%. To put this in perspective, the implied volatility of January 2012 options for the S&P500 was 26%. It is only important to understand that implied volatility is a measure of risk—higher implied volatility means higher risk. In June 2010, intermediate-term government bonds had a risk level that about 40% of that of the S&P500.
Now let’s look at conditions today. IEF, which holds bonds which mature in 7-10 years, has a current yield of 3.01%, and put options on IEF which expire in January of 2012 (same ones I analyzed back in my previous article) have implied volatility of 11.7%. In other words, the cost of “insurance” against a drop in the prices of these bonds does not reflect a strong sense of concern that the U.S. will default.
A Strange Point in Financial History
Rarely in financial history has the market been willing to loan the U.S. government money as cheaply as is the case today—this is reflected by the remarkably low bond yields on Treasuries. In addition, the options prices do not suggest that the demand for ‘insurance’ against a big sell-off in government bonds is high at all. For those who are worried, the good news is that you can buy protection against the presumed impact of a default and/or downgrade of U.S. bonds very cheaply.
With all due respect to Credit Suisse and the other experts who are warning about a looming catastrophe, the market as a whole clearly does not see a default or downgrade as imminent. The experts and media may be right and the markets may be wrong—it has happened before—but I will take my cues from the market on this.
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