What’s next for Mainland China’s property sector?
Mainland China’s property sector has experienced unprecedented volatility over the past two years. After a raft of defaults and credit downgrades, which triggered a substantial drawdown in U.S. dollar-denominated bonds, recent government policies have driven a strong rebound since last November. However, investors wonder if further upside is possible and, if so, which segments are most attractive? In our view, the road ahead is likely to be bumpy but select opportunities still exist in the U.S. dollar-denominated high-yield space. Robust credit selection and valuation assessment have become even more important considerations in the current market environment.
Mainland China’s property sector has suffered a painful two years on the back of a shifting regulatory landscape and deteriorating economic conditions. After the Chinese government promoted (the unofficial) Three Red Lines policy in August 2020, property developers faced a new and challenging operational landscape when acquiring financing. The required deleveraging, coupled with uncertainty over future sales and liquidity, led China Evergrande, one of the largest developers at the time, to default in late 2021.1
The event contributed to a negative feedback loop: Developers, unable to gain financing, stopped work on existing projects and canceled new ones, limiting cash flow. Meanwhile, consumers stayed on the sidelines as property prices fell amid growing uncertainty and slowing economic growth.
The zero-COVID policies of the last three years added to the pressure as sudden lockdowns and halted economic activity further dented already fragile consumer sentiment. As a result, the property sector experienced a cascade of defaults, credit downgrades, and withdrawn credit ratings in 2022.
Overall, the J.P. Morgan Asia Credit Index (JACI) China Real Estate Index (total return) suffered a 71.4% loss from May 2021 to November 2022;2 however, the Chinese government released a raft of new policies in late 2022 to bolster the beleaguered sector.
The People’s Bank of China and the China Banking and Insurance Regulatory Commission issued 16 measures in November 2022 to boost sector liquidity and ensure the completion of unfinished property projects. The policies ameliorated the prevailing illiquid funding environment while reducing overall default risk.
The noted change in government policy tone and the faster-than-expected exit from zero-COVID catalyzed a market rally. The JACI China Real Estate Index rebounded roughly 100% between early November 2022 and late January 2023, retracing roughly 40% of its losses since May 2021, while remaining well below precrisis levels.3
Drawdown and rebound in Mainland China’s property sector
Source: Bloomberg, J.P. Morgan Asia Credit Index/China/Real Estate/cumulative total return index, as of January 31, 2023. It is not possible to invest directly in an index.
What’s next after the rally?
With the recent strong rebound in performance, investors may be asking: Do opportunities still exist in the space and, if so, which segments are attractive?
We believe that the sector is unlikely to suffer a drawdown comparable to 2021/2022 again; the recently released policies, coupled with the reopening of the economy, have likely put a floor in the broader market.
Having said that, we also believe the opportunity set in this space has narrowed in light of recent market action. Indeed, opportunities in the quality U.S. dollar-denominated high-yield space are more selective in nature and require robust credit research to separate the contributors from the detractors.
To understand where the potential opportunities lie, we must first look at the challenges the sector still faces.
2023: challenges remain amid economic uncertainty
In 2023, we foresee a broadly stabilized funding environment for investment-grade credits, but it should remain difficult for some of the weaker high-yield names. Indeed, offshore defaults may still occur amid the nascent economic recovery and continued ructions in the property sector; however, we believe they won’t have the same deleterious market impact as they did in 2021/2022.
Perhaps, more important, we see macroeconomic recovery potentially playing a more critical role in 2023 along with sector-based policy initiatives. Government policy played a critical role by supporting tepid investor sentiment in 2022. Yet the government will likely assess the market’s reaction to existing policies and may introduce further measures to enhance existing initiatives after the National People’s Congress is held in early March.
At this point, the government is likely focused on preventing the emergence of systemic risk in the sector and could intervene further if weak economic growth prevails. Therefore, we believe economic growth and improved consumer sentiment should be the main catalyst behind further credit improvements in 2023.
Housing sales depend on sustained recovery and rising consumer sentiment
While we’ve witnessed some progress on the supply side through government policy, property demand is still a challenge. Indeed, primary home sales remain volatile and haven’t achieved consecutive months of growth, thereby indicating weak signs of recovery. We’ve seen some positive developments in secondary home sales; however, these transactions primarily benefit exiting homeowners, not developers.
Top 100 developers aggregate contracted sales (2019-2023)
Source: CRIC (www.cricchina.com) and Manulife Investment Management, as of January 2023. -43% represents the change in contract sales in January 2023 versus the four-year average (January 2019-2023).
Overall, we believe that sustained recovery of primary home sales is unlikely until at least the second half of 2023. This is because housing sentiment is broadly tied to consumer sentiment, which has only started to recover with the reopening of the economy since late 2022.
Although retail sales ended 2022 with three consecutive months of contraction and remain far below pre-COVID-19 levels,4 positive signs of improving sentiment were observed during the Lunar New Year period. Further, unemployment levels remain elevated relative to the historical average, particularly among younger workers. Any recovery is expected to be gradual.
With government policy aimed at stimulating broader consumption demand—coupled with improving sentiment—primary property sales should gradually stabilize.
Overall, we don’t expect real estate generally or home sales specifically to return to previous levels. The sector’s halcyon days, when it accounted for roughly 20% to 30% of the country’s GDP, are well behind it. That said, a sustained recovery should go a long way to boost the bond prices of lagging developers, and this is where we see attractive sectoral opportunities in 2023.
Select credit opportunities in weak but not distressed names
We see potential credit opportunities in this space which can be divided into three categories.
1 Quality names within the sector are primarily large developers, including many investment-grade credits, which have already benefited from government stimulus policies. We think a large portion is already trading at fair value after the recent run-up, as investors broadly believe they will survive over the long term. We see limited opportunities for further upside in this group until we see a sustained primary sales recovery in the sector.
2 Distressed names refer to firms that have already defaulted or are in financial distress and face near-term default. Valuation for this group will likely be driven more by idiosyncratic developments in debt restructuring and asset liquidation. Given the long timeframe involved and uncertain recovery outcomes associated with this type of investment, we believe there are more attractive risk/reward opportunities elsewhere in this space.
3 Weak but not distressed firms refer to stretched developers in the high-yield space that possess the potential to survive and whose valuation remains attractive due to considerable uncertainty. Robust credit research is needed before investing in these names because they depend heavily on specific funding streams as refinancing needs arise, which is highly idiosyncratic.
We’ll look closely at two major factors that can differentiate these credits on a case-by-case basis:
- Contracted sales performance—this represents a proxy for having adequate cash flow available to service debt repayment obligations.
- Secondary sources of funding—this could include tapping onshore credit lines, asset disposals, and selling existing projects to service debt commitments. Refinancing options, however, remain limited. Although the Chinese government has recently supported banks to offer outbound guarantees for some developers to secure offshore funding, this has largely been limited to larger developers with significant assets.
These aggregate funding sources are compared against developers’ upcoming bond maturity profiles—some have bonds maturing in 2023 versus others with a longer maturity runway over the next two to three years.
Although we expect a bumpy ride ahead for the country’s property sector in 2023, select opportunities exist in the high-yield space after the recent significant market run-up. More robust economic growth, including a sustained recovery in primary home sales, could be a key condition for this group of credits to outperform. Credit selection should remain vitally important in this volatile market environment to identify credits that will outperform.
Appendix: China high-yield spread historical changes
Source: Manulife Investment Management, ICE BofA Emerging Market China High Yield Spread-to-worst Index as of February 6, 2023. PBoC refers to the People’s Bank of China. Bps refers to basis points.
1 The developer was set to formally enter default on October 23, 2021, when the grace period ended for its missed bond payment. 2 Bloomberg. JACI China Real Estate Index Total Return. The index reached its peak on May 26, 2021, and hit a bottom on November 3, 2022. 3 Bloomberg, as of January 31, 2023. 4 National Bureau of Statistics of China, as of December 31, 2022.
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