The stars align for China property bonds
Growth roaring back with a vengeance. China’s economy marches undeterred along its path of recovery with a 3Q20 gross domestic product (GDP) print of +4.9% y/y, a remarkable feat considering that the country was initially hit the hardest, being the epicentre of the viral outbreak at the start of the year. Although the figure missed consensus expectations (+5.5% y/y), one could argue that the (1) stronger-than-expected pickup in imports in September (+13.2% y/y) and (2) RMB appreciation played a part in narrowing net export growth; two factors that are not always symptomatic of broader economic malaise.
Home is where the growth is. Nonetheless, the drivers of growth have evidently been domestic activity (please refer to “Return of China’s massive domestic consumption”, 14 October 2020), as China appears to have been immunised against the viral second waves that have afflicted much of the world outside its borders. One particularly bright spot is the property sector, which saw both residential gross floor area (GFA) and average selling prices (ASP) growing 7.7% y/y and 9.5% y/y, respectively, in September.
Factors that may have contributed to the sector’s strong recovery include:
1. Hukou (户口) reform. Lifting of restrictions in further household registration (hukou) reform as part of a continuous drive for population urbanisation to raise wealth and consumption – creating expanding demand for residential property.
2. Work-from-home trends. Despite the belief-defying success in China’s reopening, expectations of more permanent shifts towards home-based activity in certain aspects of work/leisure may have elevated demand for residential real estate. Such trends are not unique to China alone (please refer to “Thematic Strategy 3Q20 - Beyond Pandemic”, 6 July 2020).
Figure 1: China residential property sales rebounded sharply post-lockdown
Source: National Bureau of Statistics, DBS
Policy intervention to curb exuberance. The sector’s performance was strong enough to warrant policymakers stepping in with tighter financing rules for property developers via the proposed “Three Red Lines” policy, which limits debt growth based on three balance sheet metrics. While this is likely to inflict some short-term pain, we believe that this is ultimately beneficial for the sector through tampering bubble formation and systemic risk.
Moreover, such forced deleveraging makes an interesting proposition for China property credits; a higher yielding asset class now guided by a government directive to improve issuer credit quality – and hence investor’s risk exposure – over the longer term.
Reading between the lines. The three metrics, corresponding thresholds, and colour classifications are listed in Figure 2. These are then applied as an overlay across the basket of major China property issuers in the USD credit space for the sake of categorisation (Figure 3).
Figure 2: “Three Red Lines” credit metric thresholds and colour classifications
Source: Media Reports, DBS
Figure 3: Classification of developers based on the “Three Red Lines”
Source: Company data, Bloomberg, DBS
Quality is the norm and not the exception. Contrary to popular suspicion, Figure 3 shows that the majority of China developers – at least those which have issuances in the USD credit space – actually fall in the lower risk “yellow” and “green” categories. While this means that these issuers are still allowed to incur additional debt, we believe that the industry as a whole would still take dressing from regulatory direction to deleverage; ultimately improving overall sectoral risk along with the guided timeline for compliance:
Liquidity metric – up till June 2021
Gearing metric – up till June 2022
Leverage metric – up till June 2023
The opportunity thus arises to gain credit exposure in a sector that will benefit from deleveraging policies through (a) the spread compression under improving credit profiles, and (b) lower expected growth in net bond issuance over the next few years.
Have your cake and eat it too. In our view, the High Yield (HY) developer credits offer the most value, seeing as average yields in these bonds exceed even equity dividend yields. This presents an unusual opportunity to move up the capital structure and still capture higher yields for income generation.
Figure 4: Credit offers better yields than equity dividends among HY China developers
Source: Bloomberg, DBS
The elephant in the room. Would stricter credit guidelines trigger accidental systemic risk? Not long after media reports began circulating about the “Three Red Lines”, solvency concerns regarding China Evergrande (3333 HK) – a large and highly leveraged property developer – emerged due to alleged cashflow tightness. The market had focused on broader systemic implications, given that Evergrande has a sizeable USD debt of c.USD19b which constitutes c.1% of the Asia credit universe and c.8% of the Asia HY market.
In our view, it does not make sense that the authorities would allow systemic risk to occur so soon after initiating a policy that was meant to mitigate against widespread financial dysfunction in the first place. We believe that such concerns were mainly responsible for the recent underperformance of the broader Asia HY universe (Figure 6); investors are thus well placed to gain exposure in the better quality HY developers while spreads have widened, especially while the broader supportive elements for HY credit remain intact (please refer to “New Fed framework favours HY over IG”, 31 August 2020).
When the stars align. While a dearth of income-generating assets continues to plague this low rates world, China property bonds stand out with (a) higher-than-average yields, (b) decent issuer credit profiles, (c) improving sectoral risk from government-led deleveraging, and (d) rising familiarity among global investors. While we broadly prefer the BB ratings category, we believe there is also value to be found among single-B-rated issuers when investors do their homework.
As it stands, one finds no shortage of reasons for China property bonds to have their place in diversified credit portfolios.
Figure 5: Asia HY universe is dominated by China property issuers
Source: Bloomberg, DBS
Figure 6: Investors are compensated for taking HY risk in Asia
Source: Bloomberg, DBS
Figure 7: Ranking China developers based on each of the “Three Red Lines” balance sheet metrics
Source: Company data, Bloomberg, DBS
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