Downgrading Asian high yield: Why we aren’t taking this risky bet anymore

• Incremental policy fine-tuning measures have been implemented since the start of this year, but indicators in China’s property market are still painting a dim picture.

• Hopes for a more substantial shift in policy tone are dimming. China is also unlikely to pivot away from zero-Covid, which will drag on the recovery of the property market.

• Private developers are falling through the cracks. While state-owned peers have performed relatively better in terms of sales, they are only a minority in the Asian high yield bond market.

• While valuations of Asian high yield are at a historical lows, its underlying fundamentals have deteriorated immensely and permanently.

• All things considered, we are now opting to stay on the defensive side, and recommend investors to reduce their exposure to the Asian HY bond market.

We had been bullish on the Asian high yield (HY) bond market as we genuinely believed that the property sector, one that is crucial to China's political and economic stability, could see a meaningful recovery. In our view, the likelihood of strong policy support, coupled with valuations already at distressed levels, had meant that Asian HY credits could offer value to long-term investors.

Despite this, following the recent developments relating to China, the economic climate for this market has changed. This has led us to take a more defensive stance not only on Chinese equities, but also high yield bonds issued by Chinese property developers, particularly those within the offshore Asian HY space. In this article, we outline the reasons why we have downgraded our view on the Asian HY bond market.

(Related article: Downgrading China: New economic regime and rising geopolitical tensions bode ill for China's future)

Policy support has fallen short of expectations

We had expected strong policy support for the property sector, including a potential pivot, from the Chinese government. After all, the property sector and its associated industries like construction and materials contribute around 25% to 30% of China’s GDP. Also, the middle class population has significant wealth tied to the property market. Any further missteps would lead to a profound impact on social stability and the economy whose growth is already slowing due to the zero-Covid policy.

However, there has been a lack of good news coming out from the sector, so much so that market confidence has continued to deteriorate. Incremental policy fine-tuning measures have been implemented since the start of this year, but indicators in the property market are still painting a dim picture.

For one, home prices sank month-on-month for a 13th month in September, underscoring little signs of a recovery in the property market (Figure 1). During the same period, sales of top 100 developers reported 15 consecutive months of double digits negative growth year-on-year (Figure 2), despite the low base (sales had already slumped in September 2021 due to the Evergrande contagion).

Figure 1: Home prices in China saw negative growth for 13 consecutive months

Figure 2: Sales of top 100 developers consistently face double-digits negative growth

Additionally, troubles may have even gone from bad to worse, with once-healthy developers now struggling to repay their debts. In particular, CIFI Holdings, which is in compliance of the Three Red Lines, was one of the latest high-profile victim. This has sparked fears that the malaise grappling the property sector is getting out of hand.

The government is no saving grace

Undeniably, the wave of measures implemented over the past year to fix the property slump is insufficient. With extensive weakness seen in the property market and confidence draining, more decisive government support is required for a meaningful recovery.

Yet, reassurance is missing when developers and investors need it the most. There was no mention of the property sector in President Xi’s speech during the 20th Party Congress, dimming hopes for a more substantial shift in policy tone. Moreover, China is unlikely to pivot away from zero-Covid, with President Xi signalling no immediate loosening of the policy. Continued lockdowns will have negative impact on home purchases, dragging on the recovery of the property market.

To make matters worse, more homebuyers could stay away from the property market as they wait for prices to fall further. More than 70% of 20,000 households in 50 cities surveyed by the People’s Bank of China (PBOC) expect home prices to remain flat or fall in the fourth quarter of 2022 (Figure 3). This is up from 67% during June’s survey.

Without much being done to restore confidence, we believe that fundamentals have deteriorated permanently. In our opinion, a vicious cycle is now happening in the property market – one that has become increasingly difficult to resolve, the longer the problem persists.

Figure 3: Households increasingly expect flat or falling home prices

Hard to find any survivors

China’s property sector is currently undergoing a structural change as well, with state-owned developers dominating the market. This is in line with the broader economy under President Xi, which has shifted away from one that is market-oriented to a top-down state-dominated growth model. State-owned enterprises (SOEs) have become the heart of China’s economy as they are seen as a tool to help advance the government’s various strategic objectives.

Meanwhile, private developers are falling through the cracks. They have increasingly underperformed their state-owned peers in terms of sales, consequently adding on to their credit stress. Additionally, homebuyers are more concerned about private developers’ ability to deliver projects, which in turn, has led to poorer sales.

Distressed private developer CIFI Holdings saw contracted sales plummet by approximately -46% year-on-year in the first nine months of 2022 (9M22). It is not alone – as shown in Figure 4, private-owned enterprises (POEs) among the top 10 developers including Sunac China, who defaulted on some onshore bonds, saw year-on-year sales growth ranging from -25% to -69% during the same period.

The contracted sales of top state-owned developers (including those with links to state-owned entities), on the other hand, saw smaller declines varying from -12% to -35%. That being said, many of them are not in the HY space. In fact, state-owned developers are only a minority in the Asian HY bond market (as represented by the Bloomberg Barclays Asia USD High Yield Index). We found that only three out of 18 Chinese HY property developers (i.e. 17%) are state-owned or have links to state-owned entities. By the number of bonds, only three out of 62 Chinese property bonds (i.e. 5%) are issued by said entities.

Figure 4: There is a distinct difference between the sales of state-owned and private-owned developers

Table 1: State-owned developers in the Bloomberg Barclays Asia USD High Yield Index

Moreover, being state-owned does not necessarily mean that these developers are in the clear either. On 31 October 2022, Shanghai-based state-backed developer Greenland Holdings said that it will likely default on a USD bond which matures on 13 November 2022. Faced with the sudden and severe impact of the Covid-19 lockdown in Shanghai earlier this year and negative market conditions, Greenland Holdings experienced around -56% year-on-year decline in sales for 9M22.

On the whole, we believe that the lack of strong policy support likely means that it is tough to find any survivors in the Asian HY space.

Underweight Asian high yield

The recent developments relating to China and its property sector have provided us with a painful reality check. While valuations of Asian high yield are at historical lows, its underlying fundamentals have deteriorated immensely and permanently. Too much confidence has already been lost, and that is unlikely to be restored without a substantial shift in policy tone (which is not coming any time soon), both on the property and zero-Covid front.

Besides, offshore bondholders (i.e. USD-denominated Asian HY debt) are at a huge disadvantage as compared to onshore bondholders. Sunac China defaulted on its offshore debt, but managed to find funds to repay its onshore debt, while CIFI Holdings said that its offshore debt problems is not expected to materially affect onshore financing arrangements as a whole. Chinese regulators instructing state-owned China Bond Insurance to offer full guarantees on CNY-denominated bond sales by a couple of developers imply that this trend is likely to continue.

All things considered, we are now opting to stay on the defensive side, and recommend investors to reduce their exposure to the USD-denominated Asian HY bond market.

Within fixed income, our preference is for SGD-centric short duration bonds. An unconstrained bond strategy found among global bond funds is also viable as it allows for a better management of interest rate risk in this tough environment. Among Asian credits, we prefer investment grade (IG) over HY as the former offers more sector diversification, consisting of relatively stable issuers and a sizable amount of SOEs which are aligned with the government’s various strategic objectives.

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Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.