Investor confidence continues to weaken

This week the Evergrande crisis remains in the news, with the possible sale of the company’s property management arm in an attempt to raise more than US$ 5 billion. Meanwhile its much smaller Shenzhen-based rival, Fantasia, has had its rating status downgraded to default or near default, after it missed its US$ 206 million remaining principal repayment.

Fantasia’s default, coming on top of weeks of speculation about Evergrande’s ability to stay afloat, has further deepened investors’ concerns about the state of China’s broader economy. Some fear that the contagion to other China property developers and associated sectors may be at a tipping point.

Two factors have added to the nervousness. Firstly, investors are concerned that a fire sale of Evergrande’s assets does not bode well for the sector as whole. Secondly, Fantasia’s payment failure came just two weeks after it had reassured the market that there were no liquidity issues and it would meet its obligations. The lack of transparency has investors wondering what other surprises may be lurking for other developers. There are also worries that hidden debt may be more widespread within the sector than previously expected.

The worst not over

As highlighted in our earlier Research Note, we do not think that the worst is over. The current liquidity crunch that has undermined Evergrande and Fantasia can be traced to the Chinese government’s imposed limits on leverage exposure in the property sector. This regulatory crackdown is likely to continue to impact developers for months to come.

As a result, high yield debt issuers in the Chinese property sector have been punished over the past few months, with the high yield property bond market significantly underperforming other HY markets this year. Now even moderate and high-grade issuers are feeling the pinch.

Figure 1: China Property Developer HY Index vs JACI HY Index

Source: Bloomberg

Broader volatility

It isn’t only the property sector that is seeing bond market weakness. The inability to repay property developer debt directly impacts the banking sector. However, we expect this impact to be limited. China’s banks have a relatively small exposure to property developer loans. Evergrande’s RMB 183 billion loan registered in 2020 is just 0.1 percent of all China bank loans, while the figure for the whole sector is only about 7 percent.

Problems in the property sector also has the potential to lead to problems in the commodities sector. In China, property currently accounts for 60-70 percent of direct demand for float glass, 40 percent cement, 37 percent steel, 35 percent copper, and 29 percent aluminum. Investors are concerned that slower demand from property developers could see commodities prices unable to retain their current strength.

China’s bond market investors are also looking for signs that the government is willing to support flailing companies. Some see an orderly, government facilitated Evergrande restructuring as a signal that this will be the case for other large issuers that share a similar fate. Little or no government support for Evergrande may leave the markets disappointed.

Not a systemic risk

While the Evergrande and Fantasia crises are causing much uncertainty, it is worth putting the current China bond market volatility within the context of the country’s long term strategies. Policies introduced over the past few years, including those aimed at achieving “common prosperity” and “dual circulation” suggest that the Chinese government is prepared for a controlled adjustment of its short term growth outlook.

It is our view that even if the current crisis spreads beyond Evergrande and Fantasia, this does not pose a systemic risk for China. Given the stringent nature of recent crackdown measures, current fallouts are unlikely to have caught the government by surprise. We would therefore not expect direct bailouts to be forthcoming for Evergrande or other adversely-affected companies. However, we would expect the authorities to step in to support the broader economy and prevent a market-wide contagion.

In light of this, we believe that credit selection is key. China’s regulatory crackdown will produce both losers and winners. We do not hold either Evergrande or Fantasia credits in any of our portfolios and are closely watching other property developers that may be at risk. That said, we continue to seek out solid credits in this space that can also demonstrate strong metrics. For BB-rated bonds that meet this criteria, we would view price drops as a buying opportunity. We will also continue to seek opportunities to acquire short dated B-rated bond investments offered by selected, high quality names.