Markets moved by misplaced optimism
Together these measures have successfully curbed speculative activity, but have also exposed the financial fragility of the country’s developers.
As a result, since September, the sector has sold off sharply. The worst of the carnage has, however, been contained within the high-yield segment, and the market has seen only a few defaults among smaller developers and zero bankruptcies among the larger names (Evergrande and Kaisa Group have yet to formally default).
At the time of writing, higher quality names have already begun to bounce back from the late October/early November sell off. This positive shift in sentiment is being driven, not by any profound change in fundamentals, but by the market’s expectations that the government will ease policy, particularly in relation to the three red lines and property loans.
In our view, this optimism is misplaced. Unlike in past cycles, in which government easing created over stimulation, we do not expect this to be replicated this time round. Instead, we expect a slow and gradual easing process as the three- and two-red line policies remain the base line of the government’s long-term policy goal for the property sector.
With a slew of onshore and offshore debt due to mature in December 2021/January 2022, we believe the sector sell-off has a few more months to run before an inflection point is reached.
What is hidden...
We are concerned by the ubiquity of hidden debt within the system, and see this as a potential tail risk in H1 2022. The lack of financial transparency across the sector has created an epidemic of off-balance sheet lending of which it is hard to know who owes what to whom.
For example, ratings agency Fitch informed the market that Fantasia Group Holding – a leading Chinese developer – had only recently disclosed “for the first time” that it had $150m of private bond liabilities that did not appear on its balance sheet or other financial statements.
Such proliferation of ‘unknowns’ adds to our ongoing caution.
On the policy side, we do not expect any meaningful easing activity from the government on the two main tools to curb speculation (i.e. the two and three red lines). Until now, authorities have done ‘just enough’ to manage systemic risk to avoid mass unemployment and protect residential homebuyers as the deleveraging of the sector takes place. We do not believe this ‘just enough’ approach is likely to change in the short or medium term.
As a result, investors with direct exposure to Chinese developers should, in our view, take steps to diversify.
Positioning: why we’re holding out
Within our credit portfolios, we are focused on holding high-quality, higher-beta investment grade names, and high-quality BBs with lower risk of hidden debt and better revenue visibility (as measured by land banks in years).
Amid signs that the market may be getting ahead of itself with regards to policy relaxation, we are holding out for more attractive entry points to emerge over the coming months as more ‘surprising’ missed coupon payments could unfold.
Our goal is to be ready to buy when we believe systemic risk is fully priced in. Meanwhile, we are targeting diversification opportunities through negative screening that identifies companies with the following characteristics: