Investors get advice on mitigating China risk

Investors concerned about a sudden slowdown in China should buy sovereign credit-default swaps and currency options, according to Morgan Stanley.

The U.S. investment bank prefers default swaps and puts, particularly on the yuan and Taiwanese dollar, to protect against a scenario in which growth in the world’s second-biggest economy slumps to 5.5 percent as the central bank tightens lending to local governments and property developers, it said in a research note dated Monday. Markets are pricing in a 10 percent chance of this happening in the next 12 months, the lender wrote.

The cost of insuring China’s debt from non-payment soared 56.2 basis points this year to 122.5 yesterday, the second- biggest gain in a CMA gauge of 40 investment-grade issuers in Asia outside Japan, as policy makers instigated the worst cash crunch in a decade in an attempt to control lending. Only perceptions of Bank of China’s risk increased more.

“The prospect of financial sector deleveraging in China increases the risk of a hard landing,” Morgan Stanley analysts led by Viktor Hjort wrote in the report. “Although the probability of the hard landing is still low, it’s not low enough to make hedging costs irrelevant.”

China’s inflation remained below the government’s target in June, while the decline in factory-gate prices extended its longest streak in a decade amid overcapacity and lower commodity costs, data released today showed.

Investors pulled money from emerging-market debt for a sixth-straight week in the period ending July 3, with China bond funds seeing another week of outflows, according to EPFR Global.

Morgan Stanley sees CDS and foreign-currency puts as the “best hedges” against a severe slowdown, as they currently price in the least risk of it taking place. Default swaps on China may surge as high as 400 basis points if the hard landing occurs, according to the note.

Yields on U.S. dollar-denominated bonds sold by Chinese borrowers surged to an average 6.58 percent Monday, just one basis point less than a 12-month high reached in June, according to JPMorgan Chase & Co. indexes.

The cost of insuring corporate and sovereign bonds in the Asia-Pacific region against non-payment fell today, according to credit-default swap traders.

The Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan dropped 5 basis points to 154.5 basis points as of 8:24 a.m. in Hong Kong, Australia & New Zealand Banking Group prices show. The measure is poised to close at its lowest level since July 2, according to data provider CMA.

The Markit iTraxx Australia index decreased 3 basis points to 131 as of 10:40 a.m. in Sydney, National Australia Bank prices show. The gauge, which has ranged from 96.1 to 149.5 this year, is on track to reach its lowest close since June 19, according to CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the private market.

Credit-default swap indexes are benchmarks for insuring bonds against default and traders use them to speculate on credit quality. Bloomberg