Evergrande logo outside an under-construction housing complex in Zhumadian, central China
AFP via Getty Images
For investors, the weather has turned ominous. Credit problems at real estate developer China Evergrande have stoked fears of contagion and a looming debt crisis in China. Investors—to cope—are going to have to watch credit default swaps again—just like they did a decade or so ago. Picking the right CDS will help investors determine just how bad the panic is getting.
A credit default swap is just what it sounds like. One party swaps the risk of a debt default with another party. It’s an insurance product. A CDS buyer is, essentially, taking out life insurance on a bond they own.
The CDS to watch isn’t China Evergrande (ticker: 3333.Hong Kong), however, That won’t tell investors anything they don’t already know. Evergrande stock is at a new 52-week low Monday, down another 10% in overseas trading. Shares are now down almost 90% from their October 2020 52-week high of $20.40 Hong Kong dollars per share.
The problem is too much debt. With today’s decline, Evergrande has about a $4 billion market capitalization and $90 billion in debt on its balance sheet, but $300 billion including unpaid bills. Fears of default are hitting markets everywhere. European stock markets are down about 2%. S&P 500 and Dow Jones Industrial Average futures are down 1.3% and 1.6%, respectively.
Evergrande debt isn’t enough to derail the global economy on its own. The problem is if Evergrande problems lead to problems for lenders to Evergrande and then for other companies that need to borrow money from banks and the bond markets. That’s the nature of credit contagion.
Figuring out all the potential impacts and exposures is difficult. Looking at CDS for HSBC (5.Hong Kong) is one good proxy for estimating contagion.
HSBC 5-year CDS is up 16% Monday. That’s a lot. And that’s the bad news. But the absolute level isn’t pointing to all-out panic yet. That’s the good news.
The absolute level has been much higher in the past, during other crises including the pandemic. HSBC CDS trading above 40 might be one level to watch to call a broader market selloff.
CDS pricing is, essentially, basis points of bond value paid a year for insurance. There are 100 basis points in a percentage point. At 40, an investor is paying 0.4% a year to insure against HSBC default.
In the coming weeks, investors will hear about debt restructurings and, potentially, bailouts for Evergrande-related banks. Tracking the HSBC CDS charts is one way to see if the steps taken to contain the crisis are working.
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