Traders use derivatives to make bets on risk. Credit default swaps (CDSs) are a derivative intended to protect a bondholder against the risk of default. CDSs pay off the bond if the company or country that issued the bond defaults.
An example may help explain the idea. Bonds can default when a company goes into bankruptcy. GM bondholders saw their investments wiped out after the automaker was bailed out. If you owned a CDS, it would have paid you the full face value of the bond when the company defaulted and the market value of the bond fell to zero.
These markets, like any other market, aren’t prefect. But CDS prices do tell us what big traders are thinking. Right now, it would cost $1.4 million to buy insurance against default on $10 million worth of five-year Greek bonds. That bond does come with a 25 percent yield, but traders think there is at least a 70 percent chance Greece will not repay its debts so it’s pretty unlikely you’ll collect that interest for very long.
Traders also hold a low opinion of debt issued by Portugal and Ireland, where credit insurance costs about $700,000 per $10 million. Spain is priced at only $255,000, so there is relative optimism that the Spanish situation isn’t bad as the press reports.
Insurance against a U.S. default costs about $50,000, and that price is up almost 20 percent since the start of this year. German default risk is lower, costing only $40,000. Oil-rich Norway, at only $16,000 is considered the safest debt in the world. Sweden, Finland, Denmark, the Netherlands, and Switzerland are all safer than the U.S.
Traders are betting real dollars that the U.S. financial picture is getting worse. Investors looking for safety might want to consider European bonds.
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