Credit default swap (CDS) is an instrument used 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 will rise, and vice versa.
On June 17, 2013, the annual payment of a credit default swap insuring against a default of a Chinese government bond for a five-year period stood at $89.66. While the price has fallen from a recent high of $111.02 on June 13, it remains above the average of ~$65 in 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 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, credit default swaps are sometimes used as speculative instruments. If investors believe China’s government bond will default, they may purchase credit default swaps in anticipation of price appreciation, as the 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. Thus, a significant move in price often points to a significant change in the fundamental outlook, while this 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 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, historic 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. Thus, companies such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), and Safe Bulkers Inc. (SB) will likely face headwinds over the next few weeks. This is also applicable to the Guggenheim Shipping ETF (SEA), which invests in large shipping companies worldwide.
However, investors can use this indicator to time their entry into these shipping companies in the future.