HONG KONG, Jan 9 (Reuters) - Credit default swaps on China have raced to a three-month high as investors brace for a surge in global bond supplies from the world's second largest economy even as liquidity conditions tighten at home.
But the spike in the cost of insurance on Chinese debt is hardly causing any jitters outside the derivatives market for such paper. In previous cases, spikes were directly related to the rising possibility of default among mainland companies, most notably in a mid-2011 episode.
Five-year default swaps in China are trading at nearly 90 basis points, their highest since September, and have risen by 20 bps during the past three weeks.
"Some momentum players are chasing the negative headlines around the money markets and likely large bond supplies are causing the spike in CDS levels," said Owen Gallimore, credit analyst at ANZ Bank in Singapore.
But in reality, what's happening is more of a "pullback" ahead of Chinese New Year from very low spreads, he said.
Reflecting the rise, net notionals or the amounts that would be paid out in the market in the event of a sovereign default, jumped to above $9 billion in the week ending Jan. 3 from last quarter's $7-$8 billion range.
Most trading in the Asian credit default swaps market is concentrated in the sovereign sector. The CDS market is widely used by foreign investors to hedge broadly their exposure to a country, not just against corporate defaults but also other local currency investments against which direct hedges are not available.
A spike in interbank money market rates in the closing days of 2013 also prompted some hedge funds outside the region to adopt defensive strategies by buying protection on their Chinese portfolios.
As domestic liquidity tightened, Chinese companies have dominated the first active week in Asian dollar bond market with issues from KWG Property, Kaisa Group, Wuzhou International, Guangzhou R&F and Bank of Communications.
"We expect supply in 2014 to be slightly higher than 2013, driven by more issuance out of China," Barclays strategist Krishna Hegde said after Asia ex-Japan posted record bond issuance volumes last year.
Standard Chartered and Societe Generale also see China dominating the issuance pipeline this year, as the expectation of tight onshore conditions drives many mainland borrowers to overseas markets.
Widening spreads in China CDS also reverse some of the excessive tightening after last year's plenum. Citigroup has encouraged investors to buying the five-year CDS in case of any sharp drops.
"Markets were euphoric after the third plenum announcements and spreads got a bit too tight and the current spike in CDS must be viewed in that context," said Eric Liu, a portfolio manager at Harvest Global Investments in Hong Kong.
The spike is more of a "retracement of some of that optimism" than an indication a significant trend has started, according to Liu, who manages nearly $3 billion in funds.
Indeed, the swings in credit default swaps haven't caused ripples in other asset classes yet. Issuance of offshore yuan-denominated bonds, or "dim sum" ones, started the year on a strong note with five firms hitting the market this week.
In the currency markets, the offshore yuan is flirting with a record high against the U.S. dollar while the non-deliverable forwards market in the Chinese currency reflects modest appreciation bets after a nearly 3 percent rise last year.
With three year AAA-rated corporate paper in China now yielding about 6 percent compared to 4 percent in November, plus growing signs borrowing costs will rise further, some macro funds are betting on credit problems erupting in some Chinese companies.
"The rise in borrowing costs comes at a time overall corporate profitability is on the decline in China," said the head of trading at a macro hedge fund in Hong Kong. "Some of these companies are staring at tough times ahead." (Editing by Richard Borsuk)