In the past few months, the Asian High Yield bond market has seen unprecedented levels of price volatility. Since 25th May 2021 the benchmark Markit iBoxx Asian Dollar HY Bond Index (IBXXAHBI) has declined -11.1% and the average yield for the single-B rated segment of the Asian market (currently at 32%) has jumped to levels unseen since the 2008 Global Financial Crisis. What makes this sell off unique is that the price action has been concentrated in just one sector, i.e. high yield China property bonds.
Average yield of 5-year Asian single-B rated USD HY bonds
Source: Bloomberg
At the start of 2021 the China property sector accounted for 46% of the entire Asian HY market outstanding and for 58% of all HY bonds maturing in the period of 2021- 2023. Although the recent price moves have seen this weighting decline it is still very much the dominant sector of the market. Since the start of 2021 China property bonds (as measured by those included in the HY Index) have returned –28.3% with the greatest declines coming in short duration issues. Consequently, the combination of the large market weighting and significant price declines for this sector has had a profound effect on the whole HY market. This singular move is even more dramatic when one considers the rest of the Asian HY market (ex-China Property) has returned +3.0% over the same period.
We believe these moves are transitory and that ultimately the severe price declines will be reversed in the medium term. Nevertheless, we do acknowledge growing tail risks in the sector that need to also be carefully considered.
This document describes the market events and conditions that have contributed to the current situation and potential scenarios we could see for both China property bonds and the Asian HY market in general in the upcoming months.
The Evolution of the China Property Market
Since 1990 China has experienced an urbanisation trend that is considered one of the greatest mass migrations in global history. As China rapidly developed its economy creating millions of jobs in the manufacturing and services sectors and rising income levels across the country, demand for residential property in cities has skyrocketed. This has naturally spawned a real estate development sector that has become the largest and fastest growing anywhere in the world. Originally a highly fragmented sector, competition for land and high investment returns has seen the industry rapidly consolidate. According to WIND data, in 2013 the market share of the 50 largest property developers in the country was 26%. By 2019 that had grown to 60%, spawning mega-scale property conglomerates with asset bases exceeding hundreds of billions of USD.
As typically seen in the real estate sector in any country the rapid growth and market consolidation has been driven to a large extent by leverage. Land and properties represent some of the most stable and marketable collateral for lenders and naturally large-scale property developers have found easy access to credit during the market boom.
China’s top 50 developers’ market share, 2013-2019
Source: UBS
In tandem with this consolidation trend, the rising demand for property has also resulted in material home price inflation. According to E-House China, between 2011 and 2021 the average price of a residential home in Shenzhen has increased from RMB26,000/sqm to RMB61,500/sqm. Up until recently, the domestic capital markets and the asset management industries for retail investors in China has been largely underdeveloped and hence physical property ownership has long been considered the most favoured asset class for individual investment in the country. This investment demand combined with the rising urbanisation trend has driven the industry and fueled home price increases across the country.
China Policy and the Three Red Lines
It is perhaps unsurprising that the combination of rapidly rising property prices and the growing systemic importance of large-scale property companies in the financial system has raised concerns for policy makers in China. For many years the authorities have attempted to address these issues through targeted pricing caps in individual cities as well as various short-term measures to reign in company leverage (so-called Home Purchase Restrictions, or HPR) although until now these measures had made little headway on the growing risk.
In August 2020 the Chinese government unveiled a new policy mechanism to control property developers leverage, commonly known as the “Three Red Lines” policy. Under the mechanism, which originally focused on the 12 largest property developers but has since been extended to include all major property companies in the country, management must report detailed financial reports to the People’s Bank of China (PBoC) and Ministry of Housing. The developers are then assessed under three key leverage and liquidity ratios and their access to new debt fund raising is limited by their performance under these criteria. Given that S&P estimated at the time of the policy launch that only 6.3% of all rated developers would be able to fully comply with all three red lines, it was expected this would have a profound effect on the sector’s leverage growth.
At the time of its introduction, we welcomed the policy. We believed placing limits on debt growth would result in greater stability for the sector and lower irrational growth which would ultimately improve credit risk across the market. For many months the market took a similar view. Developers accelerated their sales to increase their compliance of these rules and aggressive land banking was curtailed. It appeared the Chinese policy makers had found a way to engineer a soft landing for the sector and the China HY property bond market continued to flourish.
2021, a Year of Regulation
However, in the early 2021 new risks started to emerge in the market. In February, China Fortune Land a township developer, 20% owned by China’s largest insurance company Ping An, indicated it would have difficulty paying onshore liabilities as new liquidity access to the sector began to dry up. It was the first large scale default in the sector for over 5 years and it highly surprised the market considering its financially wealthy key shareholder. Subsequently, in April 2021, China’s largest distressed debt asset manager, state owned China Huarong, failed to report its 2020 financial results claiming a potential large-scale asset write down. Although the problems in Huarong were not apparently linked to the property sector, the lack of action by the Chinese government to immediately address the collapse of one of its largest state-owned financial institutions raised significant concerns about the government’s willingness to support markets in a financial crisis. State owned enterprises had been allowed to fail in the past but nothing of the scale of Huarong. As it happens the government did ultimately engineer a bail out of Huarong four months later although not before inflicting significant damage to market sentiment. A raft of government policy actions followed throughout 2021 including clamp downs on the education, internet and healthcare sectors further signaling that the Chinese government was now prepared to take a much harder line stance to push through long term policy agendas even at the expense of financial market stability. When it comes to policy control, no sector in China is more sensitive than real estate.
The Evergrande Failure
Founded in 1996 and headquartered in Shenzhen, China Evergrande Group is a residential real estate developer that rode the wave of the Chinese urbanisation wave of the past two decades. According to Xinhua News Agency, Evergrande was the world’s most valuable real estate brand in 2018. By the end of 2020, it was managing total balance sheet assets of RMB2.3trn (USD350Bn). It was well known that Evergrande’s leverage was high for the sector but its dominant market position as one of the largest companies in the country ensured ready availability of capital and by the end of 2020 the company had become the largest issuer of USD HY bonds in Asia with total notional bonds outstanding of USD24.8bn and a weighting of 7% in the IBXXAHBI (HY) Index. In the middle of 2021 however, rumours started to emerge of payment difficulties. While the company management maintained it was operating its business as usual and the company continued to service its USD bonds, speculation began to grow that access to liquidity for the company had been significantly curtailed. In the month before the Evergrande failure China’s Vice Premier, Liu He, said Evergrande’s problem was not a matter of solvency but rather an issue of liquidity stress. However, by August 2021 when the company announced its 1H21 results, which incidentally did deliver on the management’s promise to sharply reduce balance sheet debt and gearing, the USD bonds were already trading at distressed pricing levels. As more and more banks pulled their credit lines to the company, Evergrande ultimately defaulted in September 2021. The failure of China’s largest property company became headline news all over the world.
When Evergrande officially announced its default on 23rd September, its bonds had been trading at liquidation valuations for several weeks and given that its weighting in the market had already been significantly reduced, its direct influence should have been similarly limited. However, in echoes of the Lehman crisis in 2008 any optimism that the failure of Evergrande would put a line under the crisis were rapidly dashed.
Contagion spreads
According to PBoC and CEIC data, by mid-2021 loan growth to the real estate sector had fallen to <5%, its lowest level since records began. Given it is unlikely that Evergrande is solely responsible for this fall, speculation began to grow that many other property developers could fall into similar levels of liquidity stress due to a lack of bank support. In other words, although the three red lines policy was put in place to reduce aggressive overleveraging of the sector and improve stability, the sudden cutting of credit could potentially create massive near-term shocks to many developers that might be facing any asset/liability timing mismatch.
The Deleveraging of China’s property sector
Source: PBoC, CEIC Data, Capital Economics
Compounding this situation has been the government’s efforts to try and stem property price inflation. In the past year the government has maintained tight mortgage policies in most key cities across the country. Mortgage approval time that would typically take 1-2 months has extend to 4-5 months while mortgage rates have been maintained at high levels to minimise speculative activity by individual home buyers. This reduction of buyer’s credit has dampened demand resulting in a sharp fall in the physical property market. Since 1Q21 property sales transaction volumes have fallen sequentially every month and in September 2021, typically the high season for home sales, property sales volumes fell 35% YoY according to CIRC.
Residential real estate activity, in million sqm, seasonally adjusted
Source: Capital Economics
For property developers tasked with deleveraging their balance sheets, a falling physical market is far from ideal as companies are simultaneously squeezed by an inability to raise new liquidity via borrowing or asset sales.
While it has been widely hoped and indeed expected the Chinese authorities will ease policy to avoid a contagion spreading across the sector, a lack of vocal response so far from Chinese policy makers in the immediate wake of the Evergrande failure has had a chilling effect on the market and sentiment continues to be extremely weak for bond investors.
On 4th October another Chinese property developer, Fantasia Holdings, announced that it would also default on its payment of USD bonds on that date. Although Fantasia’s financial stress had been well-known by the market with its bonds at the longer end of the curve pricing at distressed levels for several weeks, this announcement still came as a surprise. The market had widely assumed the October 2021 bond would be paid given that management had expressly told investors it had the cash ready and available to make the payment while its latest balance sheet had suggested ample liquidity with reported unrestricted cash of RMB27.1bn (USD4.3bn) at the end of June 2021. In fact, the bonds were trading at a price of 98% of nominal value the day before the default.
Although at this stage we do not believe Fantasia’s accounts are dishonest, we do think Fantasia’s decision to not make the payment likely reflects the precarious liquidity situation many developers face as they must weigh up near term offshore payments against other needs for capital including paying suppliers and demands from creditors across their capital structure. It is important to remember that the accounts of Fantasia, alongside the accounts of all other property developers, are reported on a consolidated basis with cash representing the holdings across a complex legal structure of project subsidiaries, typically in the form of joint ventures with local partners. The cash held by these joint ventures may not be readily available for the holding company to pay back its bonds. While in the past issuers may have always found refinancing funds readily available from the new issue market, clearly raising money internally from onshore subsidiaries irrespective of their gearing level is proving significantly more challenging.
Although Fantasia certainly does not have the scale or leverage of Evergrande, the failure of a second property company in as many weeks has compounded a market panic pushing the whole sector to pricing at distressed levels. Many Asian based portfolio managers were holding allocations to the sector well above 50% weighting and property bonds was a highly favoured asset class for retail investors, sometimes buying their positions with leverage. On this basis we believe much of the recent selling is technically driven as less diversified funds and leveraged individual investors have been forced to liquidate their holdings.
Property remains a systemically important sector
Of course, there is a fundamental root to the distress in the sector, but we believe it is important to remember that most of this weakness is policy driven in a country that can very rapidly reverse its policy stance. From this point of view, we believe the fortunes of the Chinese property bond market has become more political than fundamental. We do not pretend to know what the long-term intensions of the Chinese leadership are regarding the management of the property sector. Indeed, in the 19th National Congress of the Chinese Communist Party in October 2017, Xi Jinping commented “houses are for living in, not for speculation” and since then it has widely been assumed that the central government has not supported the excessive growth of the sector. Nevertheless, the sector should not be completely dismissed. Property development directly accounts for 12% of China’s GDP which increases to 33% considering all property related sectors. In recent months the Chinese economy has been facing growing headwinds as COVID outbreaks have disrupted the critical supply chain components of the export sector while an ongoing energy crisis and resulting power blackouts have significantly impacted domestic heavy industries and manufacturing sectors. It remains our base case assumption that the domestic authorities will inevitably have to shift to a looser monetary and fiscal policy in the coming months. The big uncertainty remains the extent to which this will be directed to support the liquidity starved real estate industry.
Debt restructurings must be closely monitored
Notwithstanding macro policy actions, another development that needs to be closely monitored, is the government’s approach to managing the restructuring of property companies that do default, in particular Evergrande considering its large and highly convoluted capital structure. For decades high yield and investment grade Chinese USD bonds have been issued using special purpose vehicles (SPV) that reside outside of China. Despite this complicated legal structure, the market has always existed under the assumption that offshore bondholders should always enjoy a fair claim on assets in the event of distress. There has been limited testing of this hypothesis as China has very rarely allowed companies to go into a full liquidation scenario. In the past, when a Chinese bond issuer has defaulted, either the company or authorities have managed a workout that typically resulted in either a terming out of the debt profile, the introduction of a white knight investor to restore confidence in the underlying credit or simply offering a palatable haircut payout to investors.
Following the default of Evergrande, on 24th September China’s housing regulator, the Ministry of Housing and Urban-Rural Development, claimed it would take over the property developer’s accounts and stated that all funds would be placed in escrow to ensure priority is given to completing existing development projects and payments to suppliers made ahead of creditors. Although ensuring an operational going concern is not unusual, akin to a Chapter 11 framework in the US, there still appears to be some uncertainty as to how the various levels of creditors would be treated, particularly as Evergrande holds many non-property assets that are not directly linked to the property business itself but where foreign bondholders might enjoy a direct claim.
Given that the asset sale process appears to have already started after the company reported the sale of a 19.9% stake in Shengjing Bank to a Chinese SOE the treatment of offshore bondholders’ claims will need to be carefully scrutinised to gauge the level of fair treatment to creditors which could have implications across the whole HY market. Indeed, one does have to consider the tail risk that offshore bondholders are not fairly treated in restructuring scenarios. Furthermore, in a tight liquidity scenario developers face the dilemma of choosing whether to prioritise creditors or operational cash needs and may opt to willingly default as a means to reduce their liability burden if they are under the assumption authorities will protect their interests. Of course, we view this bear case as a low probability scenario as both the government and most individual company management realise that maintaining an open USD bond market access (an important fund-raising channel for the country) remains dependent on investors believing fair treatment of their claims. Nevertheless, given the current level of pricing in the sector we do not believe this is a scenario the overall market is completely dismissing.
Outlook and scenario analysis
In terms of our outlook for the market, our base case remains the expectation that we will see some form of policy easing before year end although we concede there remains some uncertainty with regard to the extent this will be explicitly directed to the property sector. Nevertheless, we are confident a shift in macro policy stance will significantly improve investor sentiment providing strong uplift to most benchmark names. One concern remains with the large amount of USD bonds that must be refinanced in early 2022. Indeed USD8-9bn worth of China HY property paper matures in each of the 1Q22 and 2Q22 across the whole HY issuer spectrum. With many bonds currently pricing at levels where new dollar bond fund raisings will be extremely challenging, we will need to see a material price uplift across the sector before December to reopen the refinancing primary market next year. In the absence of this we expect issuers will become more innovative in managing their near-term obligations to avoid the severe stigma of default. Some of these strategies could include maturity extension restructurings, discounted tenders and buybacks or refinancing using alternative asset classes such as convertible bonds or equity stake sales. Many of these methods were successfully used in the Global Financial Crisis in 2009 when Asian dollar bond issuers faced a similar challenge of reopening the market after a crisis.
Early signs are encouraging, discounted buybacks have increased significantly in the market in recent weeks, and we would not be surprised to see this scale grow in the 4Q21 potentially including full tenders which provides an efficient method for investors to offload positions while companies are able to reduce near term liquidity and leverage risk. Restructurings with maturity extensions and credit enhancement were successfully adopted by several Chinese industrial issuers in 2019 and 2020, in most cases providing return upside for investors, and could also provide a template for property issuers. Asian markets have faced financial crises before, and our base case remains a normalisation of the market in the next 12 months with relatively few developers forced into a full default.
On the other hand, one does also have to consider tail risk of both bull and bear case scenarios.
In a bull case scenario, we see the government realising the imminent threat of a property sector collapse hurting the wider domestic economy and deciding to implement an aggressive and targeted financial stimulus to the sector. Specific actions the government could take would include, large scale monetary easing through interest rate or Required Reserve Ratio cuts, relaxation of mortgage rules allowing banks to increase their quota and lower mortgage interest rates, the temporary suspension of Home Purchase Restrictions in key cities, directing state owned banks to provide direct liquidity support to property developers including allowing banks to support USD bond refinancing or even forcing State Owned Enterprises to make capital injections into distressed developers through direct stake purchases. In such a situation we would expect a sharp and immediate rebound across the whole sector (similar to the movement in Huarong bonds earlier this year). Defaults in the sector would be limited to just those that have already failed or those that face an imminent repayment stress.
In a bear case scenario, we see the government doing nothing to help support the sector and maintaining tightened monetary and credit policies for the next 12 months. Under this scenario the physical market remains depressed and contract sales continue to fall, further squeezing company balance sheet liquidity. The government would allow more large-scale developers to fail without providing any market guidance or support across the sector. As market prices for bonds remain deeply distressed, companies would see no ability to raise new USD funds to refinance their existing obligations. The strongest developers would likely be able to convince investors to accept temporary maturity extensions although more levered companies will be forced into defaults which would likely accelerate in 1H22 as more USD bonds come for maturity. Under this scenario companies could potentially realise that paying near term offshore obligations would reduce their asset coverage for their suppliers, customers and onshore creditors and many companies may willingly miss near term maturities to protect the interests of all stakeholders. Meanwhile if ongoing restructurings prove to be unfavorable and biased against offshore claims, sentiment for the whole sector could rapidly collapse, damaging hopes for a speedy normalisation of the primary market. Under this scenario we could imagine as much as 50% of the entire China property market forced into a restructuring which may or may not allow fair treatment of offshore credit claims.
The information contained herein is issued by JK Capital Management Limited. To the best of its knowledge and belief, JK Capital Management Limited considers the information contained herein is accurate as at the date of publication. However, no warranty is given on the accuracy, adequacy or completeness of the information. Neither JK Capital Management Limited, nor its affiliates, directors and employees assumes any liabilities (including any third party liability) in respect of any errors or omissions on this report. Under no circumstances should this information or any part of it be copied, reproduced or redistributed.
