Credit default swap (CDS) is an instrument investors use to protect a debt investment from defaulting over a specific period in exchange for a payment. Like insurance, the price of a credit default swap depends on the expected likelihood of default. When the probability rises, the price of a credit default swap rises, and vice versa.
On July 4, the annual payment of a credit default swap insuring against the default of a Chinese government bond for a five-year period stood at $124. While the price has fallen from a recent high of $147 on June 24, it remains above the average of ~$65 for 2013. Prices for CDS insuring Chinese government bonds rose over the past few weeks, as economic fundamentals have worsened. While manufacturing data were negative or neutral (see Every sub-index in China’s manufacturing data fell, negative for shipping [dry bulk] for more information), home prices continued to appreciate at a high rate, which limits the government’s availability to loosen monetary policy. Given Europe’s weak economy, China’s exports remain negatively affected.
Use of credit default swap
The credit default swap is useful because only major institutions, hedge funds, and companies have access to it (although it may not be surprising to see ETFs hold positions in CDS in the future). These entities generally have more information and knowledge than the general public, which gives them an edge over retail investors.
Furthermore, investors sometimes use credit default swaps as speculative instruments. If investors believe China’s government bond will default, they may purchase credit default swaps in anticipation of price appreciation, as market prices have a higher probability of default in the future (often due to worsening fundamentals). Just like shorting equities, buyers of CDS can lose a lot if they’re wrong, so they’re more careful with their homework. So a significant move in price often points to a significant change in fundamental outlook, while this trend may not always be the case in the stock market.
Interpretation of current movements
Historically, price increases in credit default swaps have followed or mirrored liquidity issues (that is, cash crunches) within the country’s financial system. Although liquidity issues will temporarily relieve when the central bank purchases securities from banks, this relief doesn’t always lead straight to economic expansion. Since credit default swaps reflect the fundamentals of China’s entire economy, while the interbank repo rate reflects the fundamentals of China’s financial system, investors can use the price of CDS to confirm the end of a downtrend.
Since it took a few months for prices of CDS to fall in 2008 and 2011, historical patterns show that fundamentals will likely worsen for a few months. In the short term (and perhaps medium term), this is negative for dry bulk shipping companies, whose demand is closely tied to China’s economy. Despite the recent fall in China’s interbank repo rates, companies such as DryShips Inc. (DRYS), Eagle Bulk Shipping Inc. (EGLE), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), and Safe Bulkers Inc. (SB) will likely face headwinds over the next few weeks.
However, investors can use this indicator to time their entry into these shipping companies in the future.
© 2013 Market Realist, Inc.