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 11, 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 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.

Effect on shipping stocks

The recent decline in credit default swap (driven by the central bank’s capital injections in order to lower interbank repo rates) was positive for 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).

Is the risk of China’s economic collapse over?

The recent decline in credit default swap (CDS) prices reflects a sense that there’s less probability China’s economy will collapse, as the central bank injected capital into banks to bring the interbank repo rates down. But is the risk over? History suggests not yet.

Credit default swap and interest rates

In the past, price increases in credit default swaps have followed or mirrored liquidity issues (that is, cash crunches) within the country’s financial system. For example, starting in 2007, interbank repo rates rose as China’s economy started to overheat due to excessive lending. The central bank increased the interest rate to cool the rates down. Due to both excessive lending and tightening measures, interbank repo rates rose higher and stood high.

As economic growth started to stall and industrial profits began to decline, credit default swaps also rose—from $25 at the end of 2007 to near $250 a year later. Although liquidity issues temporarily relieved when lower inflation due to falling economic growth allowed the central bank to loosen interest rates and inject capital into the financial system, relief doesn’t always lead straight to economic expansion. So prices for credit default swap only stopped climbing at the end of 2008.

Implications for dry bulk shipping

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. As 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 a negative and presents a risk for dry bulk shipping companies, whose demand ties closely 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.

In the short term (and perhaps medium term), this is a negative and presents a risk for dry bulk shipping companies, whose demand ties closely 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.