Investment Strategy

Our latest views on the China property sector

Nov 18, 2021

Many risks are in the price, the broad market could gradually recover over time.

Offshore China property bonds experienced the most dramatic selloff in history during the past several months, succumbing to solvency concerns under regulatory and refinancing pressure. The initial selloff began in June when liquidity issues started to surface from Evergrande and other highly levered issuers. A few defaults have taken place since then, including medium-sized developer Fantasia’s unexpected default in early October, which further sent the sector into a free fall as investors doubted issuers’ “willingness to pay”, given the firm missed a payment with cash on its balance sheet. It was exacerbated by surprising revelations of off-balance sheet liabilities, causing even better rated names to get caught up in waves of panic sell-off as investors fled to safety and played the “who’s next” guessing game. Continued volatility, together with margin funding curbs by a few major banks, also triggered rounds of margin call-induced forced selling that intensified the downward spirals. Some investors started to position for a potential spillover effect, reflected by spikes in state-owned bank credit default swaps (CDS).

More recently, the market staged a relief rally on the back of a series of issuer efforts to rebuild investor confidence, including buybacks, share placements, Evergrande’s last minute coupon payments, among others. Some marginal policy easing signals were also welcomed by the market, including guidance on relaxing onshore bond issuances, bank lending extensions and some easing of purchasing restrictions on local levels. That said, sentiment remains highly fragile.

So far around two-thirds of high yield property bonds are trading below 70, which is the level that theoretically qualifies credits as “distressed.” However, given the unprecedented pace and scope of regulatory changes (“this time is different”), low visibility on issuers’ off balance sheet liabilities, as well as uncertainty over when, or if, offshore refinancing can be resumed, there is no consensus over a proper threshold for “being distressed” this time around, and the current market pricing is more driven by sentiment rather than fundamental assessment. We would also note that it is hard to generalize what the implied default rate is, given the wide dispersion of recovery rate assumptions in the market.

That said, some broad conclusions can still be drawn. First of all, very few in the market still hope for a reversal of regulatory tightening in the property sector, or believe that significant monetary easing is coming. Second, very few expect developers with high gearing to receive a bailout from the government. That being said, a complete meltdown of the sector, and thus widespread contagion into the banking sector - as well as global assets - is also not the base case.

Indeed, the property sector is already facing a deep downturn. National property sales contracted by 24%, the worst single monthly pace of growth outside of March 2020. Broadly, sentiment deteriorated across the board. Tier one cities saw sales down 18% y-o-y. Promotions and discounts are becoming more commonplace. Secondary market transactions also cooled considerably. In second tier cities, sales are down 23% y-o-y, with many cities seeing only half of September’s sales level. The sharp slowdown, during what typically is the peak season for housing sales, underlies the challenges facing China’s property sector developers.  

We expect policymakers to take the necessary steps to prevent a deeper downturn and maintain economic stability. To this end, some, but not all of the unconfirmed reports floating in the markets have recently been confirmed. For example, several state-owned property firms have already applied to issue bonds in the interbank market. It is also possible that asset-backed securities resume, and M&A loans are exempted from the Three Red Lines policy. More measures to help developers with re-financing in the bigger onshore market are possible. Local governments will likely also continue to make incremental adjustments to support their local housing markets. We also think credit growth has already bottomed and could gradually start to improve from here.

At the same time, in our base case, we don’t expect a big reversal of existing regulations – and given property taxes are potentially on the horizon, this means underlying property sales and investment growth could be under pressure for some time. That said, both developers and the government will most likely attempt to ensure the existing pipelines of projects get completed, and that overall sales and investment growth do not contract on a sustained basis. In our base case we have factored property investment slowing to -10% in the coming months. This amounts to a 1ppt annualized drag on GDP growth from the baseline and could have an impact on related sectors such as materials, commodities, as well as emerging markets more generally. Economies most exposed to a China slowdown are commodity producers including Chile, Australia and Brazil, and Asian economies including Vietnam, Malaysia, Taiwan, and Korea. For the China high yield property market, this means there will likely continue to be uncertainty, and differentiation will likely persist. Nonetheless, in our base case many risks are already in the price, so the broad market will likely gradually recover over time.

There is a heavy schedule of maturity due in December and Q1 2022, and that refinancing window is at best shaky, even for the highest-rated private sector developers. Thus, there is a need to stay cautious in the next few months. Indeed, after the recent recovery, rating agencies have rushed to downgrade individual names again, citing potential difficulties in handling upcoming payments. Combined with the fact that market liquidity generally starts to decline in December and throughout the Lunar New Year holiday, some weaker developers could still face challenges in the near term. As mentioned above, we expect policy intervention, but the timing of that remains unclear. For these two reasons, more volatility cannot be ruled out in the coming months. For investors, there are two implications. First, as we have seen before, in weak market conditions, some degree of contagion cannot be ruled out, and hence right-sizing exposures in the property sector remains prudent. Secondly, both Chinese equities (particularly developers’ equities) as well as the broad China offshore high yield market are down year-to-date, and thus direct hedges are expensive. There may be more attractive cross-asset options, both in equity markets, which may be further removed, as well as in the FX markets. 

All market and economic data as of November 18, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

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