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December 16, 2021 | GSAM Connect

Asia High Yield: Turning More Constructive on the China Property Sector

We have turned more constructive on the China property sector due to a material dovish shift in policy in recent weeks and improving liquidity conditions. The sector accounts for 19% of the Asia high yield market1 which we are overweight as we see opportunities to generate attractive risk-adjusted returns. Still-elevated default risks in the China property sector underscores the importance of active security selection, dynamic positioning and diversification.

 

What We're Seeing

Authorities in China have been tightening property regulations for half a decade to address property price appreciation and potential speculation in the real estate market. However, the scope and intensity of policy tightening since last summer2 has been unprecedented. Restrictive policies cooled the housing market in 2021, as intended, but also led to tighter financial conditions, challenging the ability of highly-geared property developers, such as Evergrande, to refinance. 

In an insight published in September, “Evergrande – Climbing Down the Property Ladder3”, we noted that financial market implications of a default at Evergrande would likely be confined to China, with limited global repercussions. We also outlined that the situation in the China property sector is fluid. Below we highlight three key developments that have led us to turn more constructive on the China property sector and in turn on investment opportunities in the Asia high yield market:

  1. Offshore debt restructuring at Evergrande. Evergrande has been having difficulties in meeting its US dollar-denominated bond obligations in recent months4 but appears to be working with the government to limit any spill-over impact. On December 3, Evergrande released a statement announcing it plans to engage with offshore creditors to formulate a restructuring plan and the Guangdong provincial government announced they will send a working team to Evergrande, at its request, to help maintain normal operations. In addition, on December 6, Evergrande announced that a risk management committee has been established to help stabilize the company. We believe these developments send a clear signal around the importance of compliance with policy direction in the property sector, allowing policymaker focus to turn towards easing.
  2. A material and coordinated dovish shift in policy. In recent weeks, we’ve observed a material dovish shift in policy across a broad array of policy institutions (see Box 1). We do not expect policymakers to deviate from the medium-term goal of deleveraging in the property sector, however, we do think recent developments will be supportive of the property sector given some of the stress had been policy-induced. We expect fine-tuning of policy settings to continue into 2022 as policymakers seek to achieve property sector stability.
  3. Improving onshore liquidity conditions. Through weekly engagements with property developers we are able to evaluate liquidity conditions and policy effectiveness in real-time. Our engagements suggest that although local liquidity conditions remain challenging, they show initial signs of improvement. These bottom-up insights serve as an important signal for our investment views. Mortgage growth increased 40% in October and 15% in November, which may also help to alleviate liquidity pressures5. In addition, the annual mortgage quota for banks will reset on January 1, 2022, thereby further supporting the availability and provision of mortgages. Moreover, the onshore bond market is showing early signs of recovery, with a growing number of state-owned enterprises issuing bonds.

Box 1: A coordinated dovish shift across an array of policy institutions

Macro. On December 6, the China Politburo, the principle policymaking committee of the Chinese Communist Party, set a pro-growth tone for policy in early 2022, emphasising stability and domestic demand. For example, the word “stability” appeared nine times in the Politburo meeting readout compared with three times last year. In addition, following Premier Li’s comments on lowering the reserve requirement ratio for banks to support the real economy, the People’s Bank of China announced a 50bps cut, effective December 15. Finally, the China Central Economics Works Conference concluded on December 10 and indicated support for more flexible policy at the city-level to ensure healthy development of the real estate sector. 

Regulatory. The China Banking and Insurance Regulatory Commission is seeking to encourage lending to the real estate sector that is consistent with promotion of “stable and healthy developments”, requesting that mortgage demand “be satisfied as a priority”. Meanwhile, the China Securities Regulatory Commission has stated that it is committed to capital market activity that supports “the normal financing needs of real estate companies”. 

 

The Investment Case for Asia High Yield

  • Growing tailwinds in the China property sector. We believe the developments outlined above present near-term tailwinds for the China high yield property sector which accounts for almost one fifth of the Asia high yield market.
  • Attractive yield in a low-yield world. The Asia high yield market provides a yield in excess of 10%6, an attractive yield in a low-yield environment. In addition, the China high yield property sector, where see an opportunity to generate attractive total returns, yields 31.9%7.
  • Opportunities for active security selection. The Asia high yield market is characterized by high dispersion and is therefore an opportunistic environment for active security selection.

Key Risks

  • Hard-landing in the property sector. Given part of the slowdown in the Chinese property sector is policy-induced, we remain mindful of potential policies that could impact property prices and related risks given the large size of the property sector and its linkages to the real economy. That said, recent policy actions have led us to grow confident in the ability of policymakers to limit negative spillovers to the broader financial system and economy. More specifically, we believe property sector risks will be company-specific and idiosyncratic in nature.
  • A liquidity crunch. The offshore funding market may not normalize for several quarters. As such, companies with US dollar bond refinancing needs may have to resort to a limited set of alternative funding options such as onshore bond issuance, shareholder support, asset sales, equity raising or exchanges with bondholder consent. Property developers that struggle to navigate this environment are unlikely to receive direct government support. As such, we expect idiosyncratic default risks to remain elevated, not least given a large amount of bonds are scheduled to mature in the coming months8.

Goldman Sachs Asset Management Investment Views

  • We are overweight Asia high yield and have diversified regional and sector exposures spanning Indian renewables and Philippines telecommunication, media and technology companies. On a relative value basis, we believe certain portions of the Asia high yield market—such as BB- and B-rated non-cyclical issuers—provide an attractive spread premium over comparable US high yield bonds.
  • In addition, as outlined above, the easing policy backdrop supports our more constructive view on the China high yield property sector, and we are biased to gradually add exposure. Our exposures are diversified across the credit spectrum, with a preference for well-established mid- to large-sized developers that have limited refinancing needs. Although we are cautious on weaker credits, we see attractive total return potential in select issuers that have defaulted due to liquidity—rather than solvency—issues. That said, we are highly selective in our exposure to this portion of the market due to the potential for elongated restructuring processes. In addition, we recognize that some issuers may not fully particulate in a sector rebound, hence we are carefully controlling exposure to this cohort of bonds.
  • Overall, we believe Asia high yield presents compelling risk-adjusted total return potential, with high yields providing attractive compensation for perceived risks. Furthermore, we believe rigorous bottom-up analysis, in-depth knowledge of local markets and active security selection will allow us to navigate defaults and identify bond issuers that exhibit healthy fundamentals

What We're Watching

  • Policy Impact. Looking ahead, we will continue to monitor an array of policy and property sector developments including upcoming credit data to see if property-related lending improves. We are also keeping track of housing activity data for signs of stabilization in real estate activity.
  • Policy Priorities. Big picture, Chinese policymakers are placing greater focus on objectives such as income inequality, financial stability and decarbonization. This shift entails greater tolerance for slower growth and an evolving regulatory environment in the near term for a more resilient economy in the long run. The transition to an economy that reflects these policy priorities may be susceptible to bouts of market volatility, underscoring the importance of active security selection, dynamic sector positioning and regional diversification when accessing the Asia high yield market. 

 

 

1 Source: ICE-BoAML, Bloomberg, Goldman Sachs Asset Management as of November 2021.

2 In summer 2020, the government implemented “Three Red Lines” of control on property developers’ leverage. This involves three leverage thresholds: 1) a total liability to total asset ratio (excluding presales deposit) below 70%; 2) a net gearing ratio below 100% and; 3) cash to short-term debt ratio above 1X. As of June 2021, Evergrande debt / EBITDA was 20x, while net debt / total equity was 99.9%.

3 Please reach out to your Goldman Sachs Asset Management representative to access.

Evergrande missed coupon payments due on November 6 for two of its bonds. The company had a 30-day grace period to remedy missed payments but according to Bloomberg, the payments had not been made prior to the grace period expiry on December 6.

Source: Reuters, local news sources and Goldman Sachs Asset Management.

Source: ICE-BoAML, Bloomberg, Goldman Sachs Asset Management as of December 6, 2021.

Source: ICE-BoAML, Bloomberg, Goldman Sachs Asset Management as of November 30 2021.

We estimate $5.5 billion of bonds will mature in January, followed by a further $4.9 billion in March and $5 billion in April.

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