Argentina defaults on debt. Why investors aren't panicking.

Argentina defaulted for the second time in 12 years after last-ditch talks with creditors failed.  But the cost of insuring Argentina's debt against default fell sharply on Thursday as investors speculated a deal could be struck, even if only in the long term.

Argentina defaulted for the second time in 12 years after last-ditch talks with what it called "vulture" creditors failed, though debt insurance prices on Thursday suggested investors believed a deal could eventually be reached.

After a long legal battle with hedge funds that rejected Argentina's debt restructuring following a 2002 default, Latin America's third-biggest economy failed to strike a deal in time to meet a midnight payment deadline.

The immediate focus was on whether a group of big banks and funds overseen by the International Swaps and Derivatives Association would declare the situation a "credit event".

Any such ruling would set off a series of insurance payments and give most of Argentina's current bondholders the right to demand their money back immediately. The deadline is August 4, according to analysts.

The cost of insuring Argentina's debt against default fell sharply on Thursday, however, data provider Markit said, as investors speculated a deal could be struck, even if only in the long term. The country's five-year credit default swaps fell more than 400 basis points to 1,444 bps.

"It is still not clear whether the credit default swap of the country will be triggered," said Emiliano Surballe, fixed income analyst at Bank Julius Baer. "The situation that generated the default was a lawsuit, not the failure of the country to transfer the proceeds to pay existing debt."

Argentina parked with its bankers the money to pay its current bondholders, but a U.S. legal ruling prevented it from doing so unless it paid off the holdout bondholders first.

"It's probably going to be more a soft default scenario where prices will slide a bit. There is confidence in what the government is going to do," said Rune Hejarskov, senior portfolio manager at Jyske Invest, which holds Argentinian debt.

The default could get much messier and take longer to clear up if creditors force an "acceleration" for early payment on their bonds. Some investors saw this as unlikely.

"I don't think at the moment there is a clear answer to whether bondholders will accelerate a deal. It's probably not something most bondholders would like to see," said Olivier De Timmerman, fixed income fund manager at KBC Asset Management in Luxembourg.

"My expectation is that they will eventually reach an agreement with holdouts. I do not think it will be in the short term, but likely after the foreclosures have expired towards the end of the year," he added.

The bonds at the center of the struggle had rallied strongly on Wednesday along with Buenos Aires stocks and the peso as bets on a deal rose, but traders were left up in the air after the talks fell apart.

"We expect part of (Wednesday's) rally to come back to couple of points ... Discount bond (bonds given to investors when Argentina restructured) prices will come back a bit and we will probably see a fair value around 85." said Hejarskov.

Even a short default will raise local companies' borrowing costs, pile more pressure on the peso, drain dwindling foreign reserves and fuel one of the world's highest inflation rates.

"It is going to complicate life for businesses like YPF which were going to look externally for financing," said Camilo Tiscornia, a former governor of Argentina's central bank.

VERY PARTICULAR DEFAULT

Argentina had sought in vain a last-minute suspension of a ruling by U.S. District Judge Thomas Griesa in New York to pay holdouts $1.33 billion plus interest. He ruled Argentina could not service its exchange debt unless it paid the holdouts at the same time.

A proposal for Argentinian banks to buy out the hedge funds' non-performing debt also fell through, sources told Reuters.

But it is a far cry from the mayhem following the crash in 2001-2001 when the economy collapsed around a bankrupt government and millions of Argentines lost their jobs.

This time the government is solvent. How much pain the default inflicts on Argentina, which is already in recession, will depend on how swiftly the government can extricate itself from its obligations.

"This is a very particular default, there is no solvency problem, so everything depends on how quickly it is solved," said analyst Mauro Roca of Goldman Sachs.

Buenos Aires had argued that agreeing to the hedge funds' demands to pay them in full would break a clause barring it from offering better terms than those who accepted steep writedowns in the 2005 and 2010 swaps.

That clause expires on Dec. 31, however, after which the government would be able reach a deal with the funds. Many investors and economists hope for some solution after then.

"Our base case is that a default would be cleared by January 2015," said Alberto Bernal, a partner at Miami-based Bulltick Capital Markets. He projected that a default would cause the economy to shrink 2 percent this year compared with a previous market consensus for a 1 percent contraction.

Failure to strike a deal will not cause financial turmoil abroad because Argentina has been isolated from global credit markets since its 2002 default on $100 billion of debt.

Argentina has foreign currency restructured debt worth about $35 billion while its foreign exchange reserves stand at $29 billion.

"The correction will depend on perceptions of how long the default will take to solve," said Roca.

U.S. ratings agency Standard & Poor's on Wednesday downgraded the country's long- and short-term foreign currency credit rating to "selective default". The default rating will remain until Argentina makes an overdue June 30 coupon payment on its discount bonds maturing in 2033, the agency said.

Germany, which is Argentina's biggest individual creditor, expects Argentina "to continue to respect its commitments to the Paris club" of sovereign lenders, a spokesman for the German economy ministry said on Thursday.

He said an initial partial payment equivalent to $650 million had been transferred to creditor states on July 28/29 and that Germany expected the next installment on existing arrears to be paid at the end of May 2015. "Germany can confirm receipt of such a payment," the spokesman said.

(Additional reporting by Richard Lough and Eliana Raszewski in Buenos Aires, Spriya Srivastava, Marc Jones and Andrew Winterbottom in London, and Gernot Heller in Berlin; Editing by Jeremy Gaunt)