Credit default swaps (CDS) on sovereign debt offer a way to take positions on government creditworthiness. Selling protection in this market—effectively writing insurance against default—is comparable to selling options: it promises income but comes with significant downside risk. These positions are exposed not just to economic shocks but also to shifts in market sentiment, volatility, and liquidity conditions.
This post explores how metrics of sovereign debt sustainability, particularly extrapolated debt ratios, can inform trading in sovereign CDS markets. The focus is on how changes in these indicators relate to past and future CDS returns and whether they can enhance strategy performance.
Understanding CDS as a Trading Instrument
Sovereign CDS contracts function as insurance: the buyer pays a premium to guard against a government default, while the seller earns that premium in exchange for taking on the risk. The CDS spread reflects the cost of that protection and should align closely with credit risk.
These trades are inherently asymmetric. Gains tend to be small and steady, while losses, when defaults or restructurings occur, can be sudden and large. Liquidity in these markets is often limited, particularly in emerging markets, contributing to return distributions with fat tails and negative skew.
The J.P. Morgan Macrosynergy dataset provides CDS returns across both developed and emerging markets, standardized for risk through volatility targeting. Unsurprisingly, these returns display wide variance across countries. For example, Brazil’s 5-year CDS return volatility has been vastly higher than Switzerland’s. Moreover, skewness and kurtosis statistics confirm the asymmetric, outlier-prone nature of these positions.
Using Debt Sustainability as a Signal
At the core of the analysis is a basic extrapolated debt-to-GDP ratio: where a country’s debt burden is projected to head, assuming current real interest rates, primary budget balances, and economic growth remain constant. This forward-looking metric is particularly relevant for sovereign CDS trading, where the path of fiscal health is a key driver of credit spreads.
To assess the relationship between these debt indicators and CDS returns, the study analyzes trends over multiple horizons—biweekly, monthly, annual, and biannual—while controlling for extreme values through winsorization. The goal is to isolate whether shifts in expected debt trajectories align with actual or future CDS price movements.
Link Between Debt Deterioration and CDS Returns
The first test is straightforward: does a rising debt trajectory coincide with poorer CDS returns for protection sellers? The answer is a firm yes. There is a strong contemporaneous negative correlation between increases in the extrapolated debt ratio and returns from selling CDS protection. This relationship becomes even stronger when outlier events are considered, though it is largely driven by a few extreme episodes.
The connection makes intuitive sense. As real interest rates rise or primary balances worsen, projected debt burdens climb, signaling elevated default risk and leading CDS spreads to widen—hurting protection sellers in the process.
Short-Term Predictive Power
The second, more interesting question is whether short-term changes in debt sustainability can anticipate future CDS returns. If markets are slow to price in deteriorating fiscal conditions, systematic traders monitoring these signals could gain an edge.
This appears to be the case. Short-term trends in debt ratios—particularly over biweekly and monthly periods—consistently predicted weaker CDS returns for protection sellers over the following weeks and months. The predictive signal is stronger in emerging markets, likely due to a higher frequency of credit stress events and more pronounced market inefficiencies.
Directionally, biweekly signals correctly anticipated monthly CDS returns roughly 52% of the time—a modest edge, but meaningful in systematic strategies. When applied in a simple trading framework (normalized signal strength, monthly rebalancing, and risk parity), the biweekly signal produced a Sharpe ratio of 0.6. The monthly signal, though directionally correct, showed weaker value generation.
This suggests that while CDS traders can benefit from tracking debt sustainability, timing is crucial. The market’s attention window may be shorter than in other macro contexts, making timely rebalancing essential.
Medium-Term Debt Trends and Risk Premia
The final hypothesis is more nuanced. Given that selling CDS protection is akin to selling volatility, risk premiums should rise when debt sustainability is deteriorating. In other words, after a sustained worsening of fiscal outlook, sellers might command higher premiums—if they’re willing to brave the risk.
Results here are mixed. While there is a positive correlation between worsening annual or biannual debt trends and future CDS returns, the relationship lacks statistical strength across the full dataset. It becomes more evident only in developed markets, and only after liquidity in those CDS markets improved in the late 2000s.
Naïve profit-and-loss evaluations over the full period further weaken the case. While the strategy delivered positive results in the last decade, it underperformed during earlier financial crises, suggesting that returns in such strategies may be regime-dependent and vulnerable during high-volatility periods.
Conclusion
Sovereign debt sustainability, though a simplified metric, proves to be a useful input in CDS trading. Short-term trends in extrapolated debt ratios are particularly helpful in forecasting future protection seller returns, offering both informational and economic value.
However, like all macro signals, these indicators come with limitations. Liquidity constraints, return asymmetry, and regime shifts complicate straightforward strategy implementation. Still, for those willing to combine fiscal monitoring with disciplined risk management, these metrics can serve as a valuable tool in navigating sovereign credit markets.
