Continued from Part 2
Credit default swap and the Chinese economy
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. Since prices often rise due to deterioration in economic growth, price increases often foreshadow a negative outlook for dry bulk shipping demand.
On July 12, the annual payment of a credit default swap insuring against the default of a Chinese government bond for a five-year period stood at $116.5, after hitting a recent high of $147 on June 24. Prices for CDS insuring Chinese government bonds rose over the past few weeks, as interbank repo rates rose. Although industrial output remains strong, the government’s tolerance for weaker economic growth is likely stirring concerns and risks.
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 exchange-traded funds hold positions in CDS in the future). These entities usually 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.
Effect on shipping stocks
Like the interbank repo rates, the recent decline in credit default swap (driven by the central bank’s capital injections in order to lower interbank repo rates) benefited dry bulk shipping companies such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Eagle Bulk Shipping, Inc. (EGLE), Navios Maritime Partners LP (NMM), and Safe Bulkers Inc. (SB).
Learn more about credit default swap
But is the risk gone?
Continue to Why China’s bear case economic growth will hurt dry bulk stocks (Part 4).