From the eye of the storm: African fixed income
Thys Louw reflects on recent market turmoil and assesses relative strength across this increasingly diverse investment universe.
22 Sept 2021
It has been a volatile year so far for bonds in China’s property sector. The main driver of this is Beijing’s policy of maintaining tight financial conditions in the overall economy in the face of a strong recovery in GDP growth following last year’s COVID-19 disruption. The government has specifically focused on the property sector, with the aim of preventing a speculative bubble.
Policy has been implemented at both the property developer level – via the three red-lines policy1 to contain leverage – and the banking/financial services level – via the two red-lines policy on new developer and new mortgage loan creation, alongside higher mortgage rate guidance.
While physical property markets have been resilient throughout – which explains why Beijing has been resolute in maintaining its stance – policy tightening has resulted in a number of credit events that have shaken the confidence of investors in the market. High-profile examples include the default of China Fortune Land earlier in the year and the ongoing travails of the sector bellwether Evergrande.
Add to this concerns about supply/demand dynamics (market technicals) in the sector – most regional and global investors were already overweight, with limited ability to increase exposure, and no new marginal buyers were in sight to boost demand – and the result has been a dampening of overall sentiment in the sector.
Elsewhere, the accounting issues raised by a small minority of companies during the 2020 full-year results season – including Huarong Asset Management and its delay in reporting results – have further weighed on overall risk appetite in China’s bond market.
A key concern for investors is that systemic risks in the sector have risen to a level that could overwhelm even positive individual idiosyncratic credit stories. However, we think this is an idiosyncratic story that largely relates to a very unique company: Evergrande (please see box below).
Evergrande is the largest issuer of high yield China property bonds in the offshore market and is one of the largest residential real estate developers in China, with a reported market share of 4% of national contract sales in 2020.
Evergrande’s weak credit profile is not a new development; it has been a single B rated developer since at least 2017, and, unlike many of the other 14 developers initially chosen for the pilot of the three red-lines policy, Evergrande failed to address its breach of all three in the 2020 financial year.
This, followed by a reassessment of the idea of systemic importance/’too big to fail’ within China following the Huarong episode in March 2021 and the revelations of large related party transactions involving Shengjing Bank in May 2021, were the initial catalysts for the volatility in Evergrande securities this year.
While the current tight policy setting within the Chinese property market clearly did not help, Evergrande’s woes this year were not caused by weakness in its core business – sales of residential property. In fact, Evergrande’s contract sales were resilient until August 2021, when confidence in its ability to continue to operate as a going concern became more widespread. Evergrande’s problems are more closely tied to its excessive leverage, extension of borrowing into non-traditional channels, tight liquidity, and its expansion into unprofitable and unrelated business segments, than they are to the underlying Chinese property market.
Across our EM corporate, sovereign debt and China bond strategies we do not have exposure to Evergrande and have not owned the name for a number of years, mainly given the following areas of concern:
Given the scale, speed and severity of the loss in confidence in the company and management, we think Evergrande is now likely to default and restructure. Having said that, we expect the restructuring to proceed in a controlled manner, with regulators and the banking system acting in close coordination to ensure that systemic risks do not arise, as evidenced by news that Beijing has ‘signed off on a China Evergrande Group proposal to renegotiate payment deadlines with banks and other creditors, paving the way for a temporary reprieve’. 2
We expect that the Chinese authorities will focus primarily on ensuring an orderly transition of Evergrande’s underlying property projects such that the restructuring results in neither a disorderly correction in physical property markets nor a loss in confidence in the Chinese property markets overall. We also expect the authorities to create conducive conditions for Evergrande to complete asset disposals in an orderly fashion to raise proceeds to meet its liabilities. While Evergrande has US$20 billion in offshore liabilities (chiefly in high-yield bonds), this should be considered against its US$300 billion of total liabilities, the vast majority of which sit onshore in China.
The initial episode of volatility in Evergrande did create contagion in both onshore and offshore bond markets, especially in the China property sector, but the degree of contagion/sensitivity to Evergrande has been declining with time as investors digest the initial shock.
We do not consider that Evergrande’s default and restructuring will be systemic: while Evergrande is a large borrower in both onshore and offshore markets, we believe Chinese banks’ direct exposure to the company is limited, at no more than 1% of their total loan book. We estimate that the systemically important ‘big four’ banks (ICBC, China Construction Bank, Bank of China, Agricultural Bank of China) have no more than 0.5% of their total loans exposed to Evergrande. Banks’ earnings could take a small hit if they need to set aside provisions against the exposure, but this won’t have any material negative impact on their credit profile or trigger systemic risk, in our opinion.
Post 1H 2021 company results, which showed clear dispersion in the real estate sector between relative winners and losers, there has been further discrimination and separation between individual names, underscoring that contagion is likely to decline from here.
In contrast to Evergrande, we think the forward-looking view of the broader real estate sector provides a better picture from a credit perspective. We also continue to expect improving credit fundamentals from the stronger companies in the sector, while acknowledging that there will be dispersion, and weaker companies will struggle. For example, a number of companies in the sector have managed to improve their compliance with the three red-lines policy requirements as of 1H 2021. Companies that successfully navigated this policy will have taken managerial decisions that are very much aligned with the interests of policy makers, creditors and fixed income investors, and it would be counter-intuitive for these companies to be treated the same by the authorities (and markets) as companies that have not.
While we expect overall policy to remain tight, any incremental change should be stable to slightly looser, as evidenced by the RRR cut announced in July. Furthermore, with sector yields so dislocated, we expect the better issuers to re-examine their financing plans and for new supply in bonds to abate, thereby improving the technical picture in terms of supply and demand.
Chinese real estate is a sector we continue to like, and we believe it offers significant spread compression potential. For perspective, we would note that the sector has widened to similar yields and spreads in prior episodes of volatility before subsequently recovering. In fact, China property bonds have traded at similar levels as recently as 2018, when concerns about a slowing physical property market and Sino-US tensions were foremost in the minds of investors. With valuations at attractive levels, we believe we are adequately compensated for the risk here and remain overweight the sector. We remain on the look-out for relative value opportunities as pricing dispersion persists.
Risks to our view include the authorities taking longer than expected to work out a swift transition, and that weighing on homeowner sentiment at a time where we expect house-buying activity to slow due to seasonality effects. In this scenario, we would expect more market volatility followed by swift corrective policy given how systemically important the real estate market is to China’s overall economy.
1 This relates to three “red lines” for developers to avoid: a liability to asset ratio of more than 70%, a net debt to equity ratio of over 100%, and cash to short-term debt ratio of less than 100%.
2 China Allows Evergrande to Reset Debt Terms to Ease Cash Crunch, Bloomberg, 9 September 2021.