Hedging TBill Ladder Principal Risk With Credit Default Swaps
A few weeks ago, the US Government hit its debt ceiling of $31.4T, and a political impasse on raising the debt ceiling has caused uncertainty amongst government bond holders. If the ceiling isn’t raised, the government can’t issue new debt, and if it can’t do that, current debt holders risk not getting the money they lent the US government back in time. To hedge their downside risk, startups with large Treasury positions have recently started exploring U.S. credit default swaps. In this post, we explore T-bill ladders, the debt ceiling, and credit default swaps. We also share how you can hedge your principal risk should you have a large T-bill position—let’s dive in!
An overview of TBill Ladders
Treasury bill ladders, also called ‘T-Bill ladders’, involve the purchase of T-Bills with varying maturity dates between 1-12 months. Upon maturity, these T-Bills pay out the full face value, which can be either rolled into new T-Bills with longer maturities or withdrawn into operating accounts to satisfy short-term working capital needs. T-Bills play an important role in startups’ treasury management strategy as they produce relatively risk-free, predictable, and recurring returns, which is helpful for forecasting and cash flow management.
To accomplish this, startups structure T-Bill ladders by first forecasting their cash needs and determining their investable amount. Then they select a time horizon and allocate capital between the rungs, also known as “spacing”, based on their forecasted short-term capital needs. After determining their ideal structure, startups purchase the T-Bills either through a broker or through TreasuryDirect (government site).
For most startups, the most important aspect of a treasury management strategy that involves T-Bill ladders is balancing returns and liquidity with principal risk—which brings us to startups’ recent interest credit default swaps.
An overview of the US debt ceiling
The debt ceiling was first introduced following World War One. It gave the Treasury Department the ability to raise funding for the government by issuing debt (T-bills and T-notes). Since its introduction, the debt ceiling has been raised 78 times, most recently in 2021. From 1970 to 2000, total US debt reached $5T—in the two decades that followed it grew by more than 4x to $25T. Today, just two years later it stands at $31.4T, to say it's exponentially growing is an understatement. So where does all this debt come from?
The debt comes from the sale of U.S. Treasuries to investors inside and outside the U.S. As of today, the majority of the outstanding US debt (~75%) is owned by the public, the rest is owned by the U.S. Federal Government. For a more in-depth look at the debt ceiling check out this article published by the congressional budget office on the federal debt and the statutory limit.
The influence of rate hikes on the debt ceiling and debt payments
Over the past year, the Fed has raised rates eight times. Over the same period, the interest paid on existing debt went from just 1.6% to nearly 6%. While it’s a far cry from the highs of the 1990s, the interest payments are much much larger. Why?
Well as stated above, the total outstanding debt in the ’90s was just $5T. Even at 15%, the annual interest payment on the debt was just $750B. Today, with over $31T of debt at 6% APR, the annual interest payments are nearly $2T—more than the transportation, housing, and food and nutrition service budgets combined.
With annual interest payments now exceeding actual departmental budgets, one might wonder why the US Government doesn’t just pay down the debt. Well, the reality is that paying down too much debt too quickly would cause ripple effects throughout both the domestic and global economy. Why?
Well, U.S. banks rely on Treasuries and overnight REPOs to add/remove liquidity throughout the banking system, foreign governments purchase T-Bills as a store of value, and international central banks hold T-Bills as dollar-denominated assets, given that the U.S. dollar is still the world's reserve currency. Check out this article from NPR for a more in-depth look at how the debt ceiling could sink the economy.
The outcome of failing to pause or raise the debt ceiling
The consequences of not increasing the debt ceiling would be dire: the government would default on its debt, the economy would crater, the stock market would crash, and trillions of dollars of bondholder value would evaporate overnight. In addition, the credit rating of the US Treasuries would likely drop from AA+, as they did in 2011 when they were downgraded from AAA to AA+.
This would cause the long-term borrowing cost for the Federal Government to skyrocket, further inflaming the issue. Ultimately resulting in the US Dept. of Treasury stopping the coupon payments on its T Bills. If that happened, all of the funds locked up in T Bills would cease to generate returns. Until then, T Bills remain one of the safest and highest-yielding securities available to startups.
An overview of credit default swaps
Credit default swaps are a form of financial derivative that enable investors to swap their credit risk with another investor. They’re effectively a form of insurance, that for pennies on the dollar, provides downside protection if a “credit event” occurs. Credit events cause the CDS seller to settle the contract and pay out the face value of the underlying security or in some cases cover the principal losses incurred by the buyer.
According to Investopedia, these “credit events” include failure to pay, a default other than failure to pay, obligation acceleration, repudiation, moratorium, obligation restructuring, and government intervention.
Credit default swaps are typically used for fixed-income products like bonds, securitized debt, and treasury bills. In these scenarios, the investor purchases a credit default swap to transfer the principal risk to another individual. They pay the individual in exchange for guaranteeing that they will receive the face value of the underlying security as well as all interest payments that would have been paid out between that date and the maturity date if there is a credit event. Like insurance policies, credit default swaps are maintained via recurring premium payments.
Credit default swaps as an insurance policy for TBills
As mentioned above, the US Government recently hit its debt ceiling of $31.4T—limiting the Treasury Department’s ability to issue new debt. While the government hasn’t ever defaulted on its debt and has enough cash reserves to continue operating until 4Q, 2023, there is an increased risk. As such, some of the startups who leverage Arc’s treasury management solution, have asked about credit default swaps to hedge their principal risk.
These startups aren’t alone, according to Axios, the demand for credit default swaps is on the rise with “U.S. CDS hitting an all-time high of 83 basis points”. In layman's terms: it now costs $83 to insure $10,000 of Treasury bonds against the risk of default, up from just $20 two months earlier. For context, the price today is higher than the previous record high of $82 set in July 2011, during that debt-ceiling crisis.
Even though there is an increased risk of default today and demand for credit default swaps is on the rise, it’s important to note that U.S. Treasuries are considered one of the most risk-free assets in the financial world. Axios says “they're the bedrock on which almost everything else is constructed. The U.S. can always print the money it needs to repay its debts.”
We tend to agree, which is why we keep arguing that T-Bills are one of the most important elements of a startup’s treasury management strategy.
Final thoughts on hedging T Bill ladder principal risk with credit default swaps
For startups who have funds locked in T-bill ladders and are nervous about the future, these credit default swaps may be the ideal way to hedge your principal risk, and further protect your capital. They are relatively low cost, they are fairly easy to set up, and you may not even need to hold them for long, as the premium paid on the swap is likely to continue to rise as we approach the back half of 2023 and the risk of default increases.
If you are interested in credit default swaps as a part of your treasury management strategy as a means of hedging the tail risk on your T-Bill ladders, reach out—we’d be happy to help.