China credits: a challenging outlook for real estate
On September 22, China Evergrande (Evergrande), a property developer in China, announced that it had negotiated an agreement with onshore bondholders for a scheduled interest payment;¹ meanwhile, its U.S. dollar-bond interest payment due on September 23 remain unfulfilled.² Overall, weakening liquidity conditions among real estate developers still pose numerous challenges for the sector moving forward. We explore the implications of recent market volatility for real estate credits, highlighting the need for careful research and robust credit selection to identify potential long-term opportunities in the sector and the broader high-yield space.
Looking beyond a single event: the implications for the sector
Evergrande is a real estate developer with a significant operational footprint in China—it’s the second largest in the country by sales,³ and holds both onshore (Chinese yuan, CNY) and offshore (U.S. dollar, USD) debt obligations. Amid deteriorating liquidity conditions over the past few months, the issuer failed to make scheduled interest payments to banks, and, at the time of writing, continues to face the risk of a potential default.⁴
Although this company’s future remains uncertain, we believe the market’s base case—according to the current pricing of its bonds—is likely a default. Therefore, the main issue is whether the default process will be orderly or disorderly. We think the nature of the potential default should then be a key driver of China’s real estate sector outlook, which should evolve over a longer period of time.
Short term: Property developers, in general, will continue to experience tight liquidity conditions. Although we don’t believe banks will call in existing loans, they’re unlikely to extend further credit under current conditions. In addition, property developers could find it difficult to issue new bonds, both in the onshore and offshore markets.
Medium term: Over a longer timeframe, the specifics of a potential default should be critical as operational issues come into focus. If the default is orderly, supply chain disruptions could be minimized. Under a disorderly scenario, spillover from weakening liquidity may seep into supply chains. This will lead to increased financial stress among upstream suppliers, making it more difficult for developers to deliver projects.
Regardless of the outcome, we expect industry consolidation to accelerate during this period, and polarization should deepen as stronger property developers could purchase development projects from financially weaker competitors.
Long term: The deleveraging of the property development sector should continue as one of the benefits over the longer term. Since the release of the “three red lines"⁵ policy in August 2020, the Chinese government has actively sought to reduce the level of debt used in the sector. Although there will likely be a significant and painful transition period, we believe that the industry should ultimately emerge stronger and head into an era of sustainable growth, defined by developers with lower debt levels, more stable cash flows, and more sustainable business models.
Broader implications: mitigating systemic risk and upholding social stability remain top policy priorities
Overall, we believe that a potential default scenario should be manageable for the affected financial counterparties and the broader economy.
The Chinese government has dealt with numerous high-profile and complex financial issues in the past, including the bankruptcy of Baoshang Bank and the restructuring of HNA.⁶ In addition, the amount of affected bank and trust loans isn’t significantly high,⁷ since many of the lending banks (particularly those that are state owned) are well capitalized. For instance, the People’s Bank of China (PBoC) has conducted comprehensive annual stress testing exercises for banks, including a recent testing of the banks’ specific exposures to property developers.⁸
We think there may be potential second-order impacts if there is any disruption to the delivery of properties to homeowners, or supply chain issues that lead to an uptick in unemployment at the local level. However, in these circumstances the People’s Bank of China is likely to step in with short-term liquidity, as the Chinese government has made it clear it will mitigate systemic risk and uphold social stability.
Opportunities: careful credit selection in the sector and high-yield space remain key
As seen in financial markets last week, the situation is fluid and volatility remains elevated. According to the ICE Bank of America High Yield Emerging Markets Corporate Plus China Issuers Index, credit spread-to-worst versus government debt was 1,581 basis points (bps) on September 22, 2021, higher than the 1,436bps of July 30, 2021, when the market was concerned about this entity’s potential default.⁹
In such an uncertain environment, we believe that the remainder of 2021 should remain volatile for the Chinese property sector both from a fundamental and market perspective; therefore, we believe that careful credit selection will be key to outperformance.
Indeed, as part of Manulife Investment Management’s credit selection and review process, we continually research credit names and assess them based on an array of financial metrics. We’ve recently taken an analytical deep dive into the liquidity levels and cash flow ratios of regional property developers, as liquidity concern is known to be a key contributing factor to default.
In our view, investors who are interested in the sector should take a comprehensive look at the fundamentals of any property developer and focus on the medium-term impact we described earlier. Generally, we believe that developers with decent scale and a robust financial buffer should be able to ride through different market cycles. These firms tend to have ample land reserves, either nationwide or in major economic clusters, where they hold leading market positions. In addition, we favor real estate developers with access to diversified funding channels in both the onshore and offshore markets—this is critical to the developers’ liquidity positions as well as their long-term success.
Conclusion: real estate is part of the larger structural reform agenda
Overall, we believe investors should view potential changes in the real estate sector, such as deleveraging, as part of a more significant policy focus in China on substantive structural reforms.
Indeed, over the past few months we’ve written on significant policy changes in the education and internet industries aimed at lowering costs for families and improving workers’ pay and treatment. The same analytical lens should likely be used for real estate. Although the sector has traditionally been a driver for economic growth through the use of leverage, we believe the government envisages a more sustainable and equitable real estate market. In our view, this is good news for investors seeking long-term opportunities in China.
1 Nikkei Asia, September 22, 2021. The agreement was reached through negotiations with creditors off the clearing house, meaning the specifics of the agreement haven’t been made public yet. 2 Nikkei Asia, September 24, 2021. China Evergrande misses a bond payment deadline and has 30 days to catch up before it's considered in default. 3 Due to the highly fragmented nature of the industry, Evergrande only accounted for around 4% of total market share, Fitch Ratings, September 14, 2021. 4 Bloomberg, September 22, 2021; Nikkei Asia, September 24, 2021. 5 The People’s Bank of China and the Ministry of Housing and Urban-Rural Development released the three red lines policy in August last year. The three red lines refer to: 1) liability-to-asset ratio (excluding advance receipts) of less than 70%; 2) net-gearing ratio of less than 100%; 3) cash to short-term debt ratio of more than 1x. If selected property developers cross any of the aforementioned red lines, they’ll face restricted access to debt financing. 6 “HNA Group to be broken into four independent units as Chinese conglomerate’s restructuring enters final stretch,” South China Morning Post, September 20, 2021. 7 According to J.P. Morgan, the troubled property developer accounted for 0.15% and 2.66% of system bank loans and trust loans, respectively. 8 Reuters, April 14, 2021, and The Straits Times, June 9, 2021. The People’s Bank of China began stress testing exercises in 2009 and has gradually expanded its scope to 4,024 banks in its 2021 exercise, compared with just 1,550 institutions in 2020. 9 Bloomberg, as of September 22, 2021.
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