Investor Insights -
The Year of the Tiger – The Case for Chinese High Yield Property
Global investors are being presented with an opportunity to acquire Chinese high yield property bonds at a significant discount and the debate has begun at Investment Committees around the world as when to potentially allocate.
Why consider Chinese high yield?
This debate is red-hot because the Chinese property sector is undergoing a material transformation as the government is pushing debt-ridden developers to curb debt, lower leverage, and boost liquidity through extensive regulations. This has resulted in extremely attractive bond valuations, providing a potentially lucrative entry point. While the Chinese government is expected to go to any lengths to keep the property sector stable, it is even more likely in 2022 since the 20th Party Congress will be held the second half of the year. This is evidenced by a brief statement made mid-March by China’s top financial policy body, vowing to ensure stability in capital markets and solve the risks engulfing the property sector.
Red teaming, a well-known technique used by the CIA, is now commonly practised by executives before engaging in high-stakes decisions such as corporate mergers, key acquisitions, or senior hires. Simulations, vulnerability probes, and analyses help management teams identify weaknesses, challenge assumptions, and anticipate potential threats, which gives decision makers a chance to step back and think critically about the risks and rewards.
At the latest quarterly Investment Committee, the Arbuthnot Latham Investment team engaged in a red teaming exercise to analyse the pros and cons of an allocation to Chinese high yield property bonds within the fixed income bucket of our flagship discretionary portfolios. An allocation to Chinese high yield bonds would represent an off-benchmark position for the team, therefore careful consideration is required before making the decision. During the committee meeting, Co-CIO Gregory Perdon made the case against the allocation, and Peter Doherty, Investment Director, made the case in favour of the allocation.
The case against
Fewer houses are being built in China as marriage rates drop. Investment demand is falling as the Chinese government pushes its agenda that ‘houses are for living, not for speculation’. Sales and construction are down and unsold inventory stands at a five-year high. Cash-strapped developers are not purchasing as much land. Default rates are rising, and the bond maturities are coming due at an alarming rate with some US$92 billion of bonds maturing this year. In early February, around Chinese Lunar New Year, developers faced a crucial repayment deadline of deferred wages for construction workers, worth an eye-watering 1 trillion yuan (US$158 billion).
The commercial paper process
Then there is the ‘ripple effect’ between developers. To conserve cash, Chinese real estate companies often pay their suppliers and sub-contractors by issuing commercial papers (CPs) like an IOU. Lately, a lot of CPs are going overdue, building towards potential defaults that can trickle into the entire value chain, freezing assets several times higher than the CP values.
Interest rates – US vs China
The last concern is diverging monetary policies between the US and Chinese central banks. The US Federal Reserve is in the process of tightening financial conditions by increasing interest rates and ending its bond purchasing programme, which may send the dollar higher. This contrasts with the People’s Bank of China, which is becoming more dovish and is lowering interest rates which would typically result in a weaker renminbi. These diverging central bank policies could weigh on Chinese property developers for the simple reason that many of these developers have USD denominated bonds, which in renminbi terms increases their liabilities as the dollar strengthens.
The case for
Pete took the bullish case by outlining that (i) the property sector is ‘too big to fail’, (ii) the government is pushing property firms to improve their balance sheets and (iii) bond valuations have become extremely attractive.
Too Big To Fail
The Chinese property sector accounts for 15% of the total Chinese GDP and 25% if you include upstream and downstream sectors (cement manufacturers, cleaning services, and so on), making it a crucial contributor to the economy. Stability in the sector is vital and forms the backbone of the Chinese Communist Party’s philosophy. The government cannot afford too much turmoil in the sector and is expected to take action to support it, whenever required to help ensure societal harmony.
Three Red Lines
Pete’s second point highlighted the extensive regulation China has introduced to protect and secure the real estate market. The most notable is the “Three Red Lines” regulation which requires developers to curb debt, lower leverage, and boost liquidity. While there was volatility in developers’ stock prices when the regulations were imposed in 2021, we view these regulations as positive for the sector in the long-term, especially for debt investors, as these regulations will help improve the financial health of property developers. This will in turn improve their ability to service their debt, while noting that some companies will have to fail or be absorbed along the way.
High levels of debt have helped property developers experience tremendous growth over the past decade. But such levels of leverage have also enhanced the risks of default should the property sector suffer. This is what we are witnessing currently. On the flipside, should property developers succeed in deleveraging, it is more likely that they will be better placed to meet their obligations. This should ultimately benefit the bond holders.
As part of these regulations, developers are encouraged to increase cash levels while reducing leverage, thereby increasing creditworthiness. This should eventually lead to a credit ratings upgrade from current depressed levels, and hopefully, increase bondholders’ returns for those developers that survive.
Attractive bond valuations
The Chinese High Yield Property Index is down nearly 50% in the 12-month period ending in January 2022. This represents a compelling opportunity to purchase the bonds, which are pricing in a very negative outcome already. The implied default rate - the level of defaults priced into the China property high yield bond sector - stands at 40%. This means that a 40% default is already reflected in the prices and if the default rate turns out to be less than 40%, then investors stand to profit from price increase, in addition to the yield paid by surviving developers along the way.
The market usually overestimates the actual default rate. See chart below showing US high yield corporate bonds:
Source: Neuberger Berman, JPM
A company is considered to have defaulted when it misses a payment or is in breach of the covenants underlying the debt in question. But just because a company defaults on one of its bonds does not mean bond holders lose their entire investment.
While there are risks involved in any off-benchmark position, there is no question there is a huge opportunity presenting itself in Chinese developers’ bonds. Rarely are we presented with high yields in a market where the government aims to control and support a sector to such an extent. The value of these Chinese property bonds should in theory appreciate as developers de-leverage their balance sheets, leading to upgrades in their credit ratings. Earnings growth will face huge headwinds, but the government appreciates how important the stability of the property market is to the economy and political stability. The pledges made earlier in March may have been light on detail but represent the first time President Xi Jinping’s government has addressed investors’ primary concerns in one public statement. As confidence returns, bonds should stabilise and rebound.
We held the red teaming debate in late January and had our team of analysts drill down into the data to continue debating in February. The Chinese government pledged support on 16th March, seen by many as the necessary catalyst to invest. In April, the voting members of the Investment Committee decided to include Chinese high yield property bonds within our flagship model portfolios. We will continue to closely monitor the sector.
“Be fearful when others are greedy, and greedy when others are fearful.”–Warren Buffett
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