Asian High Yield Bonds - Still have a few of Hidden Gems

Highlights:

• The yield and credit spread in the Asian high yield market are normalized gradually. The current higher yield instead reflect the potential for higher returns and relative investment value in Asian high yield bonds. However, as the credit spread is below the median and average values of the past 15 years, from a valuation perspective, the market is still not considered very attractive.

• Many Chinese property developers are attempting to transition from their previous business model, which relied on the "three high model", to more sustainable development models. However, with property industry sales, project profit margins dropped to single digits or even being negative and ongoing confidence crises, we believe that the real estate industry may not recover quickly. The overall uncertainty remains high.

• Investors could seek bond investment opportunities in four sub-sectors, including (1) Japanese High Yield, (2) Australian High Yield, (3) Hong Kong developers and (4) Chinese Issuers with more international background.

Yield and Credit Spread in Asian High Yield are Normalized Gradually

Since the second half of 2021, along with the spillover effect of Chinese real estate crisis, more developers enter into liquidity crunch and debt defaults. Based on index methodology, they usually exclude the names when the issuers are nearly defaulted or distressed.

These developments led to a decreasing proportion of property developers in the Asian high yield bond index (see Chart 1), no longer making them the dominant players in the Asian high yield market. Instead, Macau and Indian companies become more significant, while high yield issuers from Japan and Australia have also been gradually included in the index, replacing some of the previous exposures to property developers.

Chart 1: Geographical Breakdown and Changes (from 2020 to now)

Since 2022, the average yield and credit spread of Asian high yield are in a higher level (see Chart 2), owing to the super yield from distressed Chinese real estate bonds. The numbers were not very representative. With more defaults of Chinese issuers, their bonds were excluded from the index. The proportion of Chinese real estate bonds decreased from around 30% to just about 8% currently.

Chart 2: Asian High Yield – Average Yield and Credit Spread

The yield and credit spread are normalized gradually. The current higher yield of 10.4% and credit spread of 5.8% instead reflect the potential for higher returns and relative investment value in Asian high yield bonds. However, as the credit spread is below the median (5.9%) and average (6.6%) values of the past 15 years, from a valuation perspective, the market is still not considered very attractive.

Overall Uncertainty Remains High in Chinese Real Estate Industry

The Chinese real estate bonds account for around 8% of Asian high yield index. The real estate sector still wields significant influence over the Chinese economy. Therefore, we cannot overlook the outlook of the real estate industry. Along with the “517 policy” introduced in May (related article) and heavy-handed measures in September (related article), the policy signs are reversed. We believe the theme has transitioned from "housing is for living, not for speculation" to the current focus on “halting falls and stabilizing” on the property market. It is expected to lead to a more stable development pattern in the real estate market.

Furthermore, we note that many property developers are attempting to transition from their previous business model, which relied on the "three high model" (high liabilities, high leverage and high turnover), to more sustainable development models. For instance, defaulted developers like Sunac, Shimao, Zhongliang and CIFI are now venturing into the property project management industry. China Vanke announced its five-year transformation plan, aiming to increase the proportion of completed property sales and focus on residential development, property management and residential leasing.

This shift might signify that property developers will increase the contribution from recurring revenues,  increase the proportion of completed property sales and reduce the proportion of sales of uncompleted properties, as well as decreasing the project turnover speed. This could potentially lower their current high operational risks.

However, with property industry sales, project profit margins dropped to single digits or even being negative (due to low sell-through rates and high land acquisition cost in the past) and ongoing confidence crises (including the consumer confidence from the demand side and the financial institution confidence which affects financing ability), we believe that the real estate industry may not recover quickly. The overall uncertainty remains high.

So, when should investors adopt a more neutral stance towards the real estate industry? We believe that three key indicators—property sales, housing construction starts and property investment—will be crucial to be monitored. As shown in Chart 3, the year-on-year growth of these indicators remains negative (or only shows low positive growth) after new policies. Only if a return to high growth rates (such as 20% year-on-year growth or above) is sustained for an extended period (at least one year or more), the property sector is likely to be bottom out.

Chart 3: Leading Indicators in Chinese Property Sector (Single month YoY%) since June 2021

Bond Investment Opportunities in Four Sub-Sectors

In the Asian high-yield market, which category of bonds deserves a closer look? Investors can seek investment opportunities in four sub-sectors, including: Japanese high-yield, Australian high-yield, Hong Kong developers, Chinese issuers with more international backgrounds.

1. Japanese High Yield

Japan's transition from a deflationary era to an inflationary environment could stimulate their consumption and investment. Meanwhile, the TSE’s corporate reform could lead the management to focus more on the company fundamentals and restore the enterprise value.

The company’s market capitalisation is an indicator of equity financing ability. As shown in Chart 4, with an increase in stock prices and equity financing ability, it will indeed reduce a company's default risk. This could depress a company's credit spread, making it easier for the company to issue debt and borrow at a lower cost, thus creating a virtuous cycle.

Chart 4: The Potential Positive Cycle between Bonds and Stocks of Japanese High-Yield Issuers

Japanese high-yield issuers can benefit from the "Japan Recovery" theme, including Rakuten Group and Nissan Motor (see Table 1). The yield to maturity of their bonds ranges from 5.3% to 6.5%, which is worth investors' attention.

Table 1: Selected Japanese High Yield Bonds

2. Australian High Yield

As one of the major resource-exporting countries, Australia's high-yield issuers are primarily metal mining companies and mining service companies, which have benefited from the booming commodity market for metals.

For example, both gold and copper prices are hovering near historical highs (see Chart 5), and iron ore has also experienced a strong rebound due to China's stimulus measures. The higher commodity prices benefit mining companies, with their revenues and profit margins expected to remain at healthy levels, which in turn supports their credit performance.

Chart 5: Trends of Gold and Copper Prices

At the same time, mining service companies are also indirect beneficiaries. The growing capital expenditure plans of mining companies (see Chart 6) will drive orders and revenues for mining service companies. If commodity prices remain elevated for an extended period, this will also benefit mining service companies, as customer orders are expected to increase. Additionally, mining service companies will have a greater likelihood of raising prices on new contracts, potentially widening their profit margins, while also reducing counterparty risk with their customers.

Chart 6: Capital Expenditure of Mining Industry

Along with the higher for longer outlook on the commodity prices, we believe that both the mining companies and mining services company would improve their credit profile, with a potential of credit rating upgrades.

Table 2: Selected Australian High-Yield Bonds

3. Hong Kong Developers

Hong Kong developers have a number of advantages, including generally low leverage, a conservative approach to land acquisition and new project investments compared to the past, strong financing abilities and a significant number of investment properties available for rental income, long-term appreciation and collateral purposes. As a result, their credit profiles are generally more stable.

Currently, Hong Kong developers are still achieving a high sell-through rate in their new project sales. The liquidity of their Hong Kong projects is not a major concern. With normal sales and operations, Hong Kong banks are willing to provide stronger financing support to developers, meaning the actual liquidity pressure on developers is not significant.

At the same time, Hong Kong developers adopt a business model with “low liability, low leverage and slow turnover”, which is completely different from the "high liability, high leverage, fast turnover" model adopted by Chinese developers. The latter is more likely to expose to the risk of capital chain rupture. It also explains why most non-SOE developers in China defaulted their debts while none of the medium-sized or large Hong Kong developers defaulted their debts.

In summary, Chinese developers are facing not only the debt crisis but also the survival crisis, with multiple developers falling in domino effects. On the contrary, the Hong Kong property market is currently experiencing an industry downturn only. Hong Kong developers' operations, sales and financing remain normal. Therefore, we believe that most Hong Kong developers have sufficient abilities to withstand the downturn in the property market. Their credit risks are quite manageable.

Investors could consider their bonds (see Table 3). Surely, investors should still pay attention to the credit profiles of individual issuers.

Table 3: Selected High-Yield Bonds of Hong Kong Developers

4. Chinese Issuers with More International Background

We believe that selecting Chinese issuers with more international backgrounds (see Table 4) provides certain advantages, while also offering higher yields.

Table 4: Comparison of Issuers with More International Backgrounds vs. Purely Chinese High-Yield Issuers

Therefore, we believe that these issuers with more International Backgrounds (see Table 5) are more resilient and generally have an advantage over pure Chinese high-yield issuers in terms of debt repayment.

Table 5: Issuers with More International Backgrounds