What’s an Evergrande?
After a torrid 2021 thus far, it seems that the end is far from over for China. The spotlight is now firmly on China Evergrande, with its well-publicised debt woes dominating headlines.
So, what do investors need to know?
In a nutshell, the real estate giant is $300 billion in debt, and the jury remains out on its offshore payments that were due on the 23rd of September. This was a long time coming – Evergrande was already under significant scrutiny since 2016, and already suffered a liquidity scare in 2020 amidst concerns over bond payments due in January 2021. While that was averted (investors waived their rights to force a payment as part of a debt-for-equity swap), that just meant kicking the can further down the road.
Why should investors care?
Here’s where the Lehmann comparisons come in – Evergrande’s sheer size, as well as the amount of debt it owes, has caused fears of contagion not unlike the 2008 financial crisis. In particular, its massive loan obligations with many financial institutions have evoked memories (and comparisons) with 2008, where issues in the property sector almost crashed the US financial system.
A further complication is that a significant portion of the company’s debt is not exclusive to investors and financial institutions. In an attempt to absolve some of its liquidity issues, the company has also resorted to selling wealth management products to many of its stakeholders, including business partners, employees, and even clients. Unwinding this portion of the debt will certainly be challenging, and has the potential to cost significant social unrest.
A default by such a big player in China’s real estate market will almost certainly continue to weigh on China’s GDP growth, which has already shown signs of weakness this year. Furthermore, considering China’s significance in the global economy, the effects are likely to spill over and weigh on global growth as well. Specifically, this could have a significant impact on global commodities and could affect many of China’s prominent trade partners, such as Australia. This was reflected in global indices last Monday - when fears were at their highest – many global equity indices saw a selloff.
Should investors be worried?
Our View: Contagion fears are severely overblown.
While an Evergrande default is a near-certainty at this point, we believe that the risks of a Lehman-esque spillover into the financial system are well overblown.
Firstly, we believe that preventing full-blown financial contagion will be the priority for the Chinese government, as it would undo much of its work in its push for sustainable growth and common prosperity. Evergrande owes a significant portion of its liabilities to small businesses, homebuyers, and even employees – and their wealth will face severe implications in the case of a disorderly resolution. Therefore, we don’t see this as a likely route for the Chinese authorities to take.
In addition, we think that it is unlikely the Chinese authorities would have been caught with their pants down. Firstly, the People’s Bank of China conducts regular stress tests on bank’s liquidity since 2009, and has recently tested for exposure to specific property exposures earlier in 2021. In addition, considering the “Three Red Lines” policy implemented by the government themselves last year likely had a major role in exacerbating Evergrande’s liquidity issues, we believe that the government should be well aware of any potential systemic risks present and are likely prepared for them.
Instead, we believe that the Chinese authorities are backing themselves to resolve this issue. In the recent past, the Chinese government has dealt with multiple high-profile defaults – with HNA and Baoshang Bank coming to mind. We expect a similar approach here, with a combination of government intervention, debt restructuring, and various entities being requested to step in and conduct “national service” as the likely method of resolution. Thus far, the government’s behaviour has backed this up – they have pledged to ensure social stability and have moved accordingly - injecting liquidity into the banking system as well as supporting smaller regional banks that have outsized exposure to Evergrande (Shengjing Bank Co.).
For the final segment of this update, we would like to provide a quick update on some of our recommended funds that are invested in the Chinese markets:
Fixed income funds update
Eastspring Asian High Yield Fund
The biggest area of concern for most investors would be in the Asian High Yield (AHY) segment. In our base case scenario of an orderly restructuring, we believe that the recovery value of the bonds will higher than their current valuations (as of 1 Oct 2021), which should be a positive for the fund.
In fact, with contagion fears likely to be overblown, there could be potential opportunities in the sector. While credit risks (particularly in the property sector) remain high and expected default rates are picking up, investors are duly compensated with a higher credit premium and the highest yields in the bond market today. In addition, valuations remain attractive (both historically and relative to peers), and we like the segment's low duration characteristics in today’s rising interest rate environment. Credit selection has also risen to be of utmost importance, as companies with weaker balance sheets (particularly in the property sector) will likely face increased refinancing risks.
We think that pockets of value exist in the
sector, particularly after the selloff, and an active approach is the best way
to identify and invest in them.
Related Reading - Fund Friday – Are Asian High Yield Bonds Still Worth Investing In?
Fidelity China RMB Bond
In the meantime, the Fidelity China RMB bond remains resilient to the shenanigans going on in the High Yield and Equity market. Year to date, it remains in the green (+2.21%, as of 30 Sep 2021), and with the asset class demonstrating With strong fundamental drivers, low-risk, and strong diversification potential (particularly to US Treasuries), the fund makes a strong case for inclusion in many portfolios.
Related Reading - Fund Friday: China RMB bonds provide relatively good yields at low risk
Figure 1: The Fidelity China RMB Fund’s defensive qualities have paid off this year
Equity Fund Update
While none of the four funds (Allianz China A-shares, JPM China Fund, UBS (Lux) – Greater China Equity & the Manulife APAC REIT Fund) have direct exposure to Evergrande, all of which have been affected by the broad selloff in the market.
The two funds with Real Estate exposure within China - the JPM China Fund (4.14%) and the Manulife APAC REIT Fund (1.87%) - are exposed to property management properties instead of developers. As the earnings for these companies are reliant on prebuilt properties and long-term contracts (3years or more), they are unlikely to be severely affected by the Evergrande situation.
Figure 2: The Evergrande selloff has been small compared to the broader market selloff this year
Interestingly, we have also noticed a widening A-H premium in Chinese equities, with A-shares of the same company currently trading at near 1.5x of their respective H-shares. This reflects the divergence in sentiment between onshore and offshore investors – with the offshore investors being significantly more rattled – and we think this highlights a potential opportunity in the A-shares market.
Figure 3: Local sentiment continues to be optimistic even as the situation unfolds
In fact, with Evergrande likely to further exacerbate a growth slowdown, we expect the government to ramp up easing measures in Q4. A-share markets are better positioned to benefit from government stimulus and are also better positioned from a regulatory standpoint. China A-shares might be an opportunity for value-seeking investors brave enough to take the plunge.
Related Reading – Common Prosperity – What does it mean for investors?
The situation remains Fluid
The situation in China remains extremely fluid, and with a series of coupon payments all coming within the next month, we are likely to see new twists in the tale. While the uncertainty of the situation is likely to continue to create volatility during this period, we urge investors to focus on the long-term.
China’s massive growth potential remains intact, and its continued attempts to reform its financial and real estate sector should be good news for investors as it creates a healthier economy in the long term. Yet again, we urge investors to stay calm and acknowledge the noise, but focus on the big picture.
All materials and contents found in this site are strictly for general circulation and informational purposes only and should not be considered as an offer, or solicitation, to deal in any of the funds or products found/identified in this site. While iFAST Financial Pte Ltd ("IFPL") has tried to provide accurate and timely information, there may be inadvertent delays, omissions, technical or factual inaccuracies and typographical errors. Any opinion or estimate contained in this report is made on a general basis and neither IFPL nor any of its servants or agents have given any consideration to nor have they or any of them made any investigation of the investment objective, financial situation or particular need of any user or reader, any specific person or group of persons. You should consider carefully if the products you are going to purchase are suitable for your investment objective, investment experience, risk tolerance and other personal circumstances. If you are uncertain about the suitability of the investment product, please seek advice from a financial adviser, before making a decision to purchase the investment product. Past performance is not indicative of future performance. The value of the investment products and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. In respect of any matters arising from, or in connection with the said research analyses or research reports, recipients of the report are to contact IFPL at 10 Collyer Quay, #26-01 Ocean Financial Centre Building, Singapore 049315, or by telephone at +65 6557 2853. Where the report contains research analyses or research reports from a foreign research house and if the recipient of such research analyses or research reports is not an accredited investor, expert investor, institutional investor or an ex-accredited investor, IFPL accepts legal responsibility for the contents of such analyses or reports to such persons only to the extent as required by law. Please note that only certain security(ies) herein are available to all investors, while the rest are only available for certain persons to invest in, such as Accredited Investors (as defined in the Securities and Futures Act) or one who invests at least S$200,000 (or its equivalent currency) per transaction. To qualify as an Accredited Investor, one needs to submit a declaration form and certain relevant supporting documents, according to iFAST’s prevailing policies and procedures.
Please read our full disclaimers on the website at ( https://secure.fundsupermart.com/fsmone/policies/328125/investment-account-terms-&-conditions).
iFAST Financial Pte Ltd (IFPL) (registered address: 10 Collyer Quay #26-01 Ocean Financial Centre Singapore 049315, Telephone: 6557 2000) holds the Financial Advisers Licence issued by the Monetary Authority of Singapore ('MAS') to conduct regulated activities of advising on securities, marketing of collective investment schemes and arranging of any contract of insurance in respect of life policies, other than a contract of reinsurance and the Capital Markets Services Licence issued by the MAS to conduct regulated activities of dealing in securities and providing custodial services for securities. While IFPL has made every effort to ensure the independence of the report's contents, IFPL's nature of business is such that IFPL and its connected and associated entities together with their respective directors, officers and staff may be involved in providing dealing or investment-related services in the abovementioned securities, and have taken or may take positions in the securities mentioned in this report, and may also act as the principal for any buy or sell trades.