Climbing a Debt-Driven Wall of Worry

How likely is it that a country will default on part or all of its national debt in the next five years?

That’s a question that we can use the reported spreads in Credit Default Swaps (CDS) for debt issued by sovereign nations to answer!

Since credit default swaps are a kind of insurance policy that only pays out if a borrower defaults against the owner of the debt, the cost of these financial instruments will depend greatly upon the likelihood of a default occurring.

That question is immediately relevant for nations like Greece and Venezuela, both of which are above the critical 50% threshold for five-year CDS spreads, suggesting that both are very likely to default on their government’s debt within the next five years.

Unfortunately, that question also applies to a number of other nations that are going through severe financial crises that are pushing them up the a debt-driven “wall of worry”. But how can we use the CDS spread data that we can find on the web to estimate what the odds are that the country in question will go into default?

We’ve sampled CDS spread data from CMA DataVision on 21 May 2011, which we used to reverse engineer a formula to estimate the cumulative probability that a nation will default on its government-issued debt within the next five years, which we’ve presented in the chart below:

We next built a tool using the relationship we found so that you can estimate a country’s likelihood of defaulting upon its national debt if you only know the mid-spread value of the Credit Default Swaps for the next five-year period that have been issued against it.

Some quick notes. First, since we sampled the data to create our default probability model on 21 May 2011, our tool’s results are best considered as being in reference to the world’s financial situation on that date.

Second, the value of CDS spreads don’t just take a nation’s default likelihood into account. Vincent Ryan at CFO.com reports that CDS’ can also reflect considerations such as “market liquidity, counterparty risks, and technical factors, such as the high leverage inherent in swaps that apply to the CDS itself”, which means that just a straight reading of the value may overstate the probability of default to some extent.

Third, and finally, we only had the data going up as far as Greece, which makes the portion of our model that projects beyond the default probability for that nation potentially less accurate than the portions of the CDS values for which we do have data.

The way we figure it though is that if we’re talking about a nation that’s in a worse situation than Greece on 21 May 2011, the accuracy of the calculation of the nation’s probability of default is perhaps the last thing with which people should be concerned. You’re more than likely well past the point of “if” and should instead be considering “when.”

Image Credit: Fidelity

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