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UK credit default swap rates spike after wave of rating downgrades

In case you're wondering how Brexit impacts the U.K.'s creditworthiness, the derivatives market may offer different clues than the bond market.

The cost of buying protection against a default on British sovereign debt using credit default swaps rose to a three-year high on Tuesday, after rating agencies rushed to slash the U.K.'s debt rating following last week's vote to leave the European Union (EU).

It now costs $48,500 a year to protect $10 million of U.K. sovereign debt for five years, compared with levels near $32,000 before the June 23 referendum, based on the mid-point of bid and ask spreads on Thomson Reuters. This came despite a sharp fall in yields on U.K. government debt, or gilts.

On its own, the absolute cost of insurance remains low, especially when compared with euro zone countries such as Italy and Spain.

The sharp pace of the increase, however, underscored how uncertainty over the U.K.'s position in Europe had undermined its credit-worthiness. Sterling has already plunged to more-than-30-year lows and stock markets have tumbled.

On Monday Standard & Poor's downgraded the U.K.'s debt rating by two notches, from AAA to AA, citing last week's referendum that approved a British exit from the European Union, depriving the U.K. of its last triple A rating. Fitch Ratings, meanwhile, moved its rating from AA+ to AA.

"In our opinion, this outcome is a seminal event, and will lead to a less predictable, stable, and effective policy framework in the U.K. We have reassessed our view of the U.K.'s institutional assessment and now no longer consider it a strength in our assessment of the rating," S&P said in a news release.

Moody's Investors Service last week lowered the outlook on U.K.'s sovereign rating to negative from stable, while affirming its Aa1 rating.

Analysts are concerned that the decision to leave the EU will hurt growth, as companies delay investment plans and consumer confidence is sapped. Feeble growth in tax receipts will make it difficult to arrest the fiscal deficit quicker.

The downgrades aren't likely to force money managers to sell their gilt holdings, however, given the dearth of highly-rated debt.

If anything, the yield on 10-year U.K. government debt fell below 1 percent for the first time on record although the declines reflect overall investor skittishness rather than faith in the government's fiscal prudence.

Nervous investors are scurrying out of assets perceived to be riskier and are betting that the Bank of England will cut rates —already at an all-time low—further to shore up the economy.

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