A Macrofinance View of U.S. Sovereign CDS Premiums

• Author: MIKHAIL CHERNOV,LUKAS SCHMID,ANDRES SCHNEIDER
• Published date: 01 October 2020
• Date: 01 October 2020
• DOI: http://doi.org/10.1111/jofi.12948

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 5 •OCTOBER 2020

A Macrofinance View of U.S. Sovereign

CDS Premiums

MIKHAIL CHERNOV, LUKAS SCHMID, and ANDRES SCHNEIDER∗

ABSTRACT

Premiums on U.S. sovereign credit default swaps (CDS) have risen to persistently

elevated levels since the financial crisis. We examine whether these premiums reflect

the probability of a fiscal default—a state in which a balanced budget can no longer be

restored by raising taxes or eroding the real value of debt by increasing inflation. We

develop an equilibrium macrofinance model in which the fiscal and monetary policy

stances jointly endogenously determine nominal debt, taxes, inflation, and growth.

We show that the CDS premiums reflect the endogenous risk-adjusted probabilities

of fiscal default. The calibrated model is consistent with elevated levels of CDS pre-

miums but leaves dynamic implications quantitatively unresolved.

THE 2008 CREDIT CRISIS brought about significant changes in the markets

for sovereign credit default swaps (CDS) of economically developed countries.

The near-zero trading volumes at near-zero premiums observed in late 2007

expanded to active trading at substantial premiums of hundreds of basis points

(bps). Although the crisis eventually subsided, premiums on sovereign CDS

remain elevated and are nowhere close to precrisis levels. In this paper, we

seek to determine the risks that are so richly compensated in these markets.

The answer may seem obvious given that CDS are designed to insure against

default. However, at the height of the crisis, the U.S. five-year protection cost

∗Mikhail Chernov is with UCLA, NBER, and CEPR. Lukas Schmid is with USC and CEPR,

and Andres Schneider is with the Federal Reserve Board. We wish to thank the Editor, Stefan

Nagel, and the two referees for the helpful feedback. We also thank Patrick Augustin, Ric Colac-

ito, Tim Johnson, Arvind Krishnamurthy, David Lando, Hanno Lustig, Batchimeg Sambalaibat,

Martin Schmalz, Adrien Verdelhan, and Paul Whelan for comments on earlier drafts of this pa-

per. We are also grateful for feedback received from participants at the 2016 BI-SHoF conference,

Mannheim Asset Pricing Conference, 2016 NBER Summer Institute, 2016 SED meetings, 2016

SITE meeting, 2016 SFS Cavalcade, 2015 Tepper/LAEF macrofinance conference, and 2016 WFA

meetings, as well as at seminars at Baruch College, Boston University, the Chinese University of

Hong Kong, City University of Hong Kong, Nanyang TechnologicalUniversity, National University

of Singapore, Singapore Management University,Federal Reserve Board, University of Michigan,

University of Zurich, University of Illinois Urbana-Champaign, and University of Montreal. The

views expressed herein are those of the authors and do not necessarily reflect the position of the

Board of Governors of the Federal Reserve or the Federal Reserve System. We have read The

Journal of Finance disclosure policy and have no conflicts of interest to disclose.

Correspondence: Mikhail Chernov, UCLA Anderson School of Management, 110 Westwood

Plaza, Suite C-417, Los Angeles, CA 90095; email: mikhail.chernov@anderson.ucla.edu.

DOI: 10.1111/jofi.12948

© 2020 the American Finance Association

2809

2810 The Journal of Finance®

100 bps, and it has traded at around 20 bps since 2014. Is a U.S. default that

likely or does the severity of the expected losses justify such premiums? Basic

reasoning suggests that the answer to both of these questions should be no.

For instance, some observers argue that the United States will never default

because it can “inflate away” its debt obligations, increase taxes, or both.

Our objective in this paper is to establish a quantitative benchmark for the

compensation based on default risk. We, thus, make a first step toward de-

veloping a formal macro-based framework that will allow us to evaluate the

likelihood of a sovereign default and the associated risk premium. The advan-

tage of such an approach is that it allows us to study the effects of monetary

and fiscal policies.

There are many good reasons to suppose there could be other determinants

of CDS premiums. For instance, frictions arising from various institutional fea-

tures of CDS markets, such as margin requirements, counterparty risk, capital

constraints, and credit event determination, could contribute to the observed

premium. We do not disagree with such a view, and leave these explanations

for future research.

Because we take a first step in addressing the questions above, we keep our

setting as simple as possible. We directly specify the dynamics of a number of

key variables, such as aggregate output, consumption growth, and government

expenditure. The glue that holds these variables together and that allows us

to investigate the questions of interest is the government budget constraint

(GBC). Because the government can tax aggregate output and issue new nom-

inal debt to finance its expenditures and repay its outstanding debt, the GBC

endogenously determines the relation between debt issuance and taxes.

We specify monetary policy via a Taylor rule that determines the behavior

of inflation. In an endowment economy, monetary policy usually does not have

real effects. In contrast, in our setting where the GBC features nominal debt,

inflation has real quantitative effects. Fiscal policy responds to the amount of

debt outstanding and expected growth in the economy.

Our model endogenously allows for states of the economy in which a bal-

anced budget can no longer be restored by raising taxes or eroding the real

value of debt by creating inflation. In such situations, the government will

be forced to default on its debt. We refer to such a scenario as a fiscal default.

Episodes of fiscal stress arise in our model because we assume that an increase

in the tax rate has a small negative effect on future long-term output growth.

Thus, attempts to achieve a balanced budget by raising taxes may reduce tax-

able income, which would further exacerbate fiscal conditions. Fiscal default

then arises when taxes cannot be raised further without reducing future tax

revenues, in the spirit of a Laffer curve. This trade-off prompts our specifica-

tion of a maximum amount of debt outstanding, that is related to government

expenditures and tax rates, and that ultimately determines the timing of de-

fault.

We complement our model with a representative agent who has Epstein and

Zin (1989) preferences and uses her marginal rate of substitution to value as-

sets. Consumption features a time-varying conditional mean similar to Bansal

A Macrofinance View of U.S. Sovereign CDS Premiums 2811

and Yaron (2004). These assumptions allow us to value nominal defaultable

securities using inflation and the timing of default implied by the GBC and

policy rules.

Qualitatively, we find that the model provides significant insights into the

macroeconomic determinants of the CDS premiums on U.S. Treasury debt. In

the model, periods of high government debt endogenously correspond to peri-

ods in which investors have high marginal utility. As government expenditures

rise, the government edges closer to the point at which further tax increases

will reduce tax income. Default probabilities and the likelihood of incurring

losses on government debt thus increase during periods of high marginal util-

ity. In turn, sellers of CDS-based protection against government distress face

missed required payments during periods of high marginal utility. To compen-

sate for their increased exposure to this risk, protection sellers charge high risk

premiums. Although the average losses on government debt are small implying

small average payments by protection sellers, defaults occur in the worst of all

states. In the context of our model, risk premiums thus make up a substantial

part of CDS premiums beyond the expected losses.

We use our model to explore a rare and severe endogenous event that may

affect the U.S. economy. Although the default is severe, exogenous consump-

tion and therefore the marginal rate of substitution are not affected. In this

sense, we are considering a mechanism that is similar to that of Barro (2006),

although without the rare disasters in consumption. One implication of this

setting is that the derived CDS premiums are likely to be conservative.

Quantitatively, we find that our model can generate periods of persistently

elevated CDS premiums, similar to recent experience in the United States. In

simulations, our model produces CDS premiums of up to 100 bps on an annual

basis, which is similar to the peak values of the U.S. CDS premiums around

the time of the financial crisis in 2008. Perhaps more importantly, our model

predicts periods of elevated CDS premiums even during calmer times because

in our setup with recursive preferences, investors anticipate and dislike occa-

sional shocks to default probabilities, which results in increased CDS premi-

ums. The model is thus consistent with the view that CDS premiums reflect

investors’ rational forecasts of the likelihood of U.S. fiscal stress.

We next use the model to revisit the idea that the government avoids de-

fault by increasing taxes or inflating government debt away. To capture these

policy responses, we change the respective fiscal and monetary policy stances.

Raising less debt or responding to inflation less aggressively leads to a decline

in the average probability of default and to increased CDS premiums. These

effects occur because such changes increase the volatility of taxes and inflation

and thus imply higher risk premiums.

Because we intentionally use off-the-shelf modeling elements, the resulting

model contains a number of simplifications. Some of the simplifications are

evident, such as the exogenous dependence of expected output on taxes and

government policies that do not change on default. However, others suggest

model misspecifications that are common to a large body of the asset pricing

literature, most notably the downward-sloping real yield curve, constant price