Lost your money investing in China property bonds? Here’s why you should continue to hold on.

What exactly went wrong?

Selling new homes before completion and delivery is a common practice in China. Why were homebuyers willing to pay in advance for a home that hasn’t even been completed? Well, for the longest time, China’s property market was red-hot (Figure 2). Property prices have been steadily rising to the point that it even seemed like the prices could only go one way up. Prospective homebuyers were inclined to pre-pay as they were concerned that prices will continue to rise again. In exchange for the pre-payments, developers promise the delivery of completed homes within an agreed period.

Figure 2: In its heydays, China’s property market experienced very solid growth

Although developers were bringing in a lot of revenue from pre-sold homes, they were also incurring large amounts of debt. In 2020, in a bid to reduce developers’ high reliance on debt for growth, Chinese regulators began to introduce new restrictions, one of which was called the Three Red Lines. Developers that failed to meet the Three Red Lines are not allowed to increase their debt.

As restrictions intensify, developers – particularly those with weaker financial standings – generally struggled to obtain financing. Several eventually faced a liquidity crunch, with insufficient cash to pay for the ongoing constructions of their projects, subsequently failing to deliver their pre-sold homes in a timely manner.

Mortgage boycotts not a widespread problem yet

Although the number of mortgage boycotts has increased rapidly, we believe that this is currently not a systemic crisis. It is estimated that the number of projects involved in the mortgage boycott represents about 1% of China’s total mortgage balance, suggesting that the crisis is still being confined to a small group of homebuyers.

We reckon that other homebuyers facing non-delivery of their homes may not have a huge incentive to join the boycott, as those who stop their mortgage payments would suffer a hit to their social credit scores. Under China’s social credit system, each citizen is given a score based on their behaviour. Their social credit score increases after performing socially desirable actions, and vice versa.

Citizens who have high scores can enjoy benefits including priority for employment, and cheaper public transport. On the other hand, citizens holding low scores could be excluded from booking flights or high-speed rail tickets (Figure 3), and their children could be excluded from private schools. While it sounds a bit like an episode of the Netflix show Black Mirror, these are really some of the consequences that mortgage boycotters could potentially face.

Figure 3: China’s social credit system in numbers

Expect strong government intervention

China would be wary of the amount of damage that a full-blown mortgage crisis can do to the entire property sector. Assuming an extensive number of homebuyers were to join the boycott, the property market would be sent on a downward spiral, with confidence in the property market expected to deteriorate further. This will put extra strain on property prices, sales, and consequently, the liquidity of developers.

It is also worth noting that the property sector and its associated industries like construction and materials contribute around 25% to 30% of China’s GDP. China is already expected to miss its 5.5% growth target due to a strict zero-COVID policy, and if this mortgage crisis is not handled properly, there will be a profound impact on the economy.

In a worst case scenario where the crisis is left to be escalated further, it can potentially trigger instability in China. The financial system would have large amounts of loan losses to absorb, and according to estimates by S&P Global Ratings, China’s banks face mortgage losses of RMB 2.4 trillion yuan if the worst were to happen.

While banks may have to deal with a blow to their earnings, China’s middle class might see the same happen to their wealth. The middle class population has significant wealth, estimated to be around 70% based on the China Household Wealth Survey Report, tied to the property market. Prolonged declines in home prices as a result of the mortgage crisis mean that middle-class home owners will be watching their wealth slip away.

While China’s property sector is facing a lot of obvious risks, we are of the view that any risk to financial or social stability should increase the sense of urgency for China to solve the problem. It is evident that stability is the top agenda for Chinese officials, as authorities have rolled out several policy fine-tuning to help stabilise the housing market (Table 1).

Table 1: Policy actions undertaken to support the property sector

We expect to see more government intervention, with policymakers likely to act quickly to contain this crisis. Local governments are expected to ensure that housing projects proceed to completion. Additionally, China is reportedly launching a real estate fund to support developers, in which the central bank would contribute an initial RMB 80 billion. Banks, too, are anticipated to play a part by increasing financial support for developers, otherwise they might end up losing a lot more money if they have to write off the loans. Meanwhile, state-owned developers may be roped in to acquire projects from weaker developers.

Key investment risks

Policy support could come too little and too late: For every passing day, if China does not take immediate action to resolve the issue, confidence in the property market will continue to deteriorate. If further support takes too long to implement, it could possibly be too late to restore confidence in the sector. Also, there is a risk that China’s rescue efforts would be insufficient to prevent a full-blown crisis.

COVID-19 lockdowns: A resurgence of cases would cause lockdowns in China to be imposed again, leading to construction halts and potentially exacerbating the issue of non-delivery of housing projects.

What does all this mean for investors?

Our base case is that the mortgage crisis will be brought under control. As mentioned, the mortgage crisis is posing a real threat to the economy, and with stability a key priority to China, regulators should act quickly to defuse the issue.

Underpinned by strong government support, we reckon that the property sector can emerge stronger from this crisis, which is a positive for bondholders in time to come. Turning to China’s property bonds, it is likely that a large degree of default risk has already been priced in by markets. The majority of bonds are already trading at distressed levels, with more than 50% of them currently valued at less than 30 cents on the dollar (Figure 4). We note that the recovery rate for high yield bonds is typically at around 40%.

Figure 4: The market is pricing in high risks of default

We continue to hold a positive view on China’s property bonds, though at the same time, acknowledging that their recovery will take longer than initially expected as a result of the mortgage crisis. While market volatility is expected to hang around for longer as the property sector tackles the challenges, government intervention – which we believe should come soon – would be the key near-term catalyst for a recovery in sentiment.

With most of the downside risks likely priced in, we think that the risk-reward of the Chinese property sector is skewed to the upside, presenting investors who have a longer-term investment horizon with an attractive entry point. Patience is also key for investors who are currently holding on to the bonds.

It is important to stay diversified

Diversification and credit selection within the Chinese property bond market remains crucial. Not all developers are made the same (e.g. state-owned developers tend to have better liquidity positions), not to mention that further policy support is anticipated to create winners within the sector.

Investors seeking to bet on the recovery of China’s property sector should consider active products, as such the Eastspring Investments - Asian High Yield Bond ASDM SGD-H as well as the Blackrock Asian High Yield Bond A8 SGD-H which exhibits stronger risk management and more resilient performance as compared to peers.

Those with stronger risk appetite could also go for products that provide a pure-play exposure to Chinese property bonds, which is currently only being offered by ETFs. The Premia China USD Property Bond ETF (HKEX:9001) is the only product available in the market that provides diversified exposure to Chinese property credits. It holds secured and senior unsecured debt securities which are likely to offer better recovery prospects in the event of a default.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in Premia China USD Property Bond ETF.