Webinar Q&A: The Evergrande Crisis And What It Means For Investors

1. What’s the road ahead for Evergrande?

It is clear now that Evergrande will utilize the 30-day grace period, to see if there are any further development or instructions from the government. We believe they will handle these coupon payments together as a whole, instead of individual repayments.

Currently, we know the Group is prioritizing the completion of residential projects, so they may try to reserve the cash for delivering houses to homebuyers first, which is not a good news to bondholders. Meanwhile, Evergrande’s asset disposal plan is starting to heat up. The Group sold stakes in Shengjing Bank and is planning to sell Evergrande Property Services.

2. What are the options for Evergrande bondholders?

Should the bonds default, offshore bondholders will have the rights to claim against the onshore and offshore assets held by China Evergrande. However, since the onshore assets mainly comprise of the debt-distressed Hengda Real Estate, it should be harder to recover. Therefore, we still believe that the Group’s most important assets are the equity ownership of several listed companies. These assets will provide some cushion for the recovery value of the bonds. The incentive to sell the bond at current price is quite low.

That being said, instead of a full liquidation, we think the most possible outcome is a debt restructuring. Referencing to past cases, it usually takes one to two years for a repayment plan to be developed during the restructuring process. While Evergrande is under the spotlight and we expect creditors to be more aggressive in taking actions, investors should still take time value into consideration.

3. What is the impact on the China, Malaysia, Singapore and India real estate market?

Over the months, the concerns regarding the potential default from the Chinese property developer, Evergrande Group has affected the overall sentiment in Asian equity markets.

China

The Evergrande crisis will have an impact on housing demand in the Chinese real estate market. Homebuyers have turned more cautious, resulting in lower transaction volumes. We expect developer’s home sales to be affected in the near term, together with a slowdown in the growth of housing prices.

Refinancing for developers is also likely to become more challenging. That being said, developers with stronger balance sheets (i.e. met the Three Red Lines) are unlikely to come under significant refinancing pressure.

Table 1: Three Red Lines

Furthermore, we expect the competition for land to recede as distressed developers slow down on land acquisition and sell assets in order to raise cash. Meanwhile, financially stronger developers could be able to acquire land at more reasonable prices, helping to support their margins.

Overall, with the increased importance of deleveraging following the Evergrande crisis, we expect growth in China’s real estate sector to slow down. As uncertainties at Evergrande continue to swirl, the negative sentiment is likely to stay in the short term, resulting in a lack of share price catalysts for the Chinese real estate sector. The negative sentiment may also spill over to Hong Kong, affecting the earnings of developers there.

Malaysia

We think that the Evergrande’s issue would have limited impact on Malaysia’s property sector given the insignificant direct exposure to China’s property market.

Malaysia’s property sector suffered a -15.4% dip in 2020 chiefly due to disruptions in the construction process precipitated by the movement control orders (MCO) which were imposed to contain the COVID-19 outbreak in Malaysia.

The prospect of the property sector remains encouraging in 2021 and 2022, here are a few factors backing the promising recovery of the industry:

1. Less stop work disruptions for on-going projects
2. Property market underpinned by encouraging housing initiatives and favorable interest rate environment

In terms of valuations, based on the forward PB (price-to-book) ratio of 0.44 times, it is evident that the property sector is trading way below its book value and could suggest that it is undervalued. We believe the low valuation is attributable to the weak investor sentiment amid continued oversupply concerns.

However, with the government-led housing initiatives and low interest rate environment, the earnings of the local property counters are expected to see meaningful recovery in 2021 and 2022 with double-digit growth of 16.6% and 17.7% respectively.

At this point, we are “neutral” on the property sector despite short-term recovery as long term prospects remain uncertain.

Singapore

Singapore residential property prices are still high and there is no visible impact from the fallout of China Evergrande. Interest rates are low and wages are growing, lending some support to home prices.

Figure 1: Singapore residential property price indices and interest rates

However, Singapore’s resident unemployment rate dropped to 3.5% in June 2021 but rose slightly to 3.7% in July. The resident unemployment rate is high relative to the pre-pandemic levels of 3.1% as at September 2019. Electricity prices and coronavirus cases have been rising in the city-state and this could dampen consumer sentiment and spending in the short term.

Looking forward to next year, as mentioned by our macro team in August 2021, we see two ensuing themes going into 2022 – “a high vaccination rate and soon-to-achieve herd immunity, as well as a continued robust economic recovery. We expect these catalysts to remain in play in 4Q21 and early 2022 but should be neutralised when growth and vaccination for regional economies catch up.”

India

We don't foresee any impact on Indian real estate players due to the Evergrande debt crisis. Indian real estate developers are domestic focused in nature, and rely primarily on Indian banks/financial institutions for financing. Currently, the sector is witnessing strong tailwinds on account of low interest rates, increased consumer confidence due to formalization initiatives, and steps taken by the government to bolster infrastructure/construction activities.

The government has also made amendments to regulations around the Real Estate Investment Trusts (REITs) to address concerns around residential real estate liquidity and financing issues. This is expected to encourage participation by foreign portfolio and institutional investors, and the sector has already seen players like Brookfield, Blackstone, and Embassy investing in commercial real estate assets.

4. What are our views on other Chinese property developers?

Market is concerned that financial institutions will not borrow to the developers anymore. At the current yield level, it becomes almost impossible for some highly leveraged developers to refinance their debts using traditional borrowings, especially for B-rated developers. We believe the sell-off is pricing in a nationwide systematic financial risk.

Despite the weakened sector fundamentals, strong demands in China are unlikely to disappear. We also believe that Chinese Government does not want to see the sector collapsing and many developers declaring bankrupt. With ‘stabilizing’ as top priority, it is likely that the government may loosen the regulations in future.

At this moment, we think more appealing investment opportunities have emerged, especially for BB-rated issuers who are dragged by the entire sector selloff instead of having any deterioration in their own credit.

5. What is the impact on Chinese banks, more specifically on the Big 4 (ICBC, ABC, CCB, BOC)?

Generally, we can expect to see an increase in loan loss provisions and non-performing loans as the Chinese banks prepare for higher defaults across their real estate developers related loans. While this is not to say that the banks are in the clear, but we believe the impact of a real estate market downturn is manageable given how the banks’ exposure to the real estate developers is not very large in comparison to the total loans on their books. The Big Four banks exposure to the real estate sector is about 5.5% on average. Construction loans make up another 2% of the banks’ total loans.

While we do not have the specific breakdown of the type of loans that are collateralised, we understand that loans to real estate developers are usually collateralised, which could help to cushion against the any further defaults in the real estate market. According to Bloomberg, the Big Four banks have about 70% of their total loans total loans secured with collateral, pledges and guarantees. Besides, the Big Four banks are also in a healthier position today thanks to their deleveraging efforts over the years, and we believe this should further ease investors’ concerns over the banks’ balance sheet. 

However, the Big Four banks may also be activated to help Evergrande to tide through some of its short-term cash flow needs, similar to what happened to Huarong Asset Management earlier this year. Therefore, we acknowledge that investor sentiments is likely to remain depressed in the near term. Valuations may fall even further but at its current level, we see more upside potential than downside risks for the Big Four banks. The Big Four banks will be one of the main beneficaries as China continue its growth to become the world’s largest economy.

6. How will the Evergrande issue impact the overall Chinese A shares and H shares market?

The potential collapse of Evergrande as well as a slowdown in the real estate sector would likely weigh on China’s GDP growth which has already shown signs of weakness this year. As a result, negative sentiment is expected to affect the performance of Chinese markets in the near-term.

We have noticed a recent surge in the A-H premium in Chinese equities, which has reached a high in at least five years. This suggests that foreign investors are shying away from Chinese equities given the regulatory uncertainties and the contagion from Evergrande.

From this perspective, valuations of H-shares are more attractive vis-à-vis A-shares. Nonetheless, an allocation to A-shares can provide diversification benefits for investors as they are better positioned from a regulatory standpoint. Major players in Chinese sectors that are likely to see supportive policy tailwinds ahead are only accessible via A-shares. This includes tech manufacturing (semiconductors, 5G infrastructure) and green initiatives (solar panels, electric vehicles).

Additionally, we believe that contagion fears are overblown by foreign investors. From the perspective of Chinese authorities, a full blown contagion just doesn’t make sense as it would undo much of China’s work in its push for sustainable growth and common prosperity. In order to ensure stability, we have also seen China injecting liquidity into the banking system and providing support to smaller regional banks that have outsized exposure to Evergrande.

While the uncertainty of the Evergrande situation is likely to continue to create volatility during this period, we urge investors to focus on the long-term prospects of China. China’s massive growth potential remains intact, and its regulatory reforms should be good news for investors as it creates a healthier economy in the long term.

7.  What are the main opportunities we see now?

Fixed Income

For Asian high yields bonds, while expected default rates are certainly picking up, the yield offered by the AHY segment have risen significantly as well – meaning that risk-seekers are also compensated with a larger credit premium now. Asia HY is currently trading at credit spread (OAS) of 9.5%, close to 3 standard deviation that of historical average level. We will elaborate further on our investment thesis on Asian HY bonds in the next question.

Asian Investment grade (IG) bond is worth considering for investors who nonetheless chooses to reduce exposure to the Asian HY segment. While yields are lower, they are much safer than Asia HY bonds. We believe that the deleveraging efforts by China government are unlikely to affect liquidity of Asia IG bond segment. In addition, Asia IG continue to provide one of the highest YTW (2.23%) among global IG bonds. It also offers the lowest duration among peers – is thus least vulnerable to a rising interest rate backdrop.

Equities

The China Financial sector was slammed with a sell-off due to worries of a spill-over effect of the Evergrande crisis to the broader market. Contrary to market, we think fears are overblown as the exposure of China banks to the RE sector is limited at current juncture. Not only that, valuations for the sector are now near the lowest in its historical range – 0.42X P/B (Big 4 Banks) – meaning that downside risks are limited. With an average dividend yield of about 9%, the Big Four banks are also very attractive yield-plays for income-seeking investors. 

For China Tech sectors (particularly Internet giants), the Evergrande debt crisis salted the wound of the prolonged regulatory overhang on the sector. Hang Seng Tech sector is down about -27% YTD (-6.4% amid Evergrande crisis), knocking valuations below fair (current 20.0X FY23E PE ratio; Fair PER is 30X). Yet, long-term growth prospect is largely intact, driven by rising internet penetration & digitalization of consumption in domestic China. Earnings growth remains highly robust given how closely integrated the Internet sector and domestic consumption have grown over the years. The recent dip has made share prices more attractive than before, giving investors the opportunity to gain exposure to the sector’s long-term growth on the cheap.

Lastly, investors tired of the prolonged regulatory crackdown in real estate and technology sectors can turn their attention to the domestic China A-share market. We believe that the domestic A-share market is better positioned for the Common Prosperity theme. Unlike offshore (H-shares, ADR) tech exposure mostly concentrated around the household Internet names (i.e. Tencent, Alibaba) that are in the crosshairs of the China regulators, Tech names in China A-shares are mostly Tech Manufacturing (Semiconductors, 5G infrastructure), and Green Initiatives (Solar Panels, Electric vehicles). These are critical cutting-edge tech that China wish to lead the world in the coming decade and will see very supportive policy tailwinds ahead.

8.  Should we buy, hold or sell Asian High Yield?

Overall, we think Asian high yield bonds (as a whole) are a buy right now. The bond segment, while faced with higher material risks, are well compensated with higher income returns. AHY is offering a yield-to-worst of 10.3% (OAS spread of 9.5%). While defaults could rise further, current valuations more than compensate for the risk.

Our investment thesis on Asian High Yield bonds remain largely intact. Asian HY bonds offers:

1. Highest yields in the entire fixed income universe today;
2. Attractive valuations, both historically and relative to peers; and
3. Resiliency to Interest Rate changes (due to its low effective duration of 2.9 years)

Investors who are afraid of specific company risks (e.g. Evergrande) can spread out the idiosyncratic risk via Asia HY funds – which is essentially a basket of credit issuers across sectors and geographical region within Asian.

9. How has the Evergrande debt crisis affected the other credit segments in the global fixed income space?

DM credit markets (US and Europe) do not have direct exposure to China bonds. Credit spreads for DM bonds barely flinched on news of Evergrande’s possible default. With an absence of direct exposure and no signs of credit stress, we expect DM credit markets to be least at risk to a spillover. Further, DM credit markets are buttressed by the prevailing easy monetary conditions engendered by their central banks which should help allay indirect credit stress.

EM credit markets have exposure to China bonds however, such exposure is relatively minor in our view. While EM HY bonds and EM hard currency debt are certainly more at risk amongst EM bonds, their aggregate exposure to China bonds is only at an estimated 3-5%. Moreover, this exposure includes China agency and sovereign bonds which are much safer in terms of credit quality. Overall, we see little signs of stress within EM credit markets, and alongside the relatively small direct exposure, we expect minor risk to a spillover.

Within the Asia bond space, we see little signs of stress from Asian IG bonds as the exposure to China bonds are largely confined to corporate IG bonds. On the contrary, Asia HY bonds have relatively higher exposure, at more than 40% (to China corporate HY) of the index. That said, despite being at higher risk to a spillover, we are not overly concern. We opine that the potential underlying impact may eventually be limited as i) the direct exposure to Evergrande bonds is small (less than 1.6% of the index), and ii) the impact is fairly localised within China’s real estate sector where not all underlying companies are as vulnerable as Evergrande.

10. How will the upcoming Fed taper and rising interest rates affect the AHY bonds? Will it exacerbate the current weakness in China real estate HY bonds?

Compared to a rise in interest in rates, consensus view asset tapering as a more immediate concern. In our view, tapering will create a tighter monetary condition which can be unfavourable for risk assets. As such, high yield bonds may be negatively affected as market moves to de-risk however, the impact for each segment varies. We believe the impact on Asian HY bonds will be relatively milder than its counterparts for the following reasons.

Firstly, as seen in prior episodes of tapering, bond markets tend to bear flatten (short term rates rises while long term rates falls) when central banks trun hawkish. So even before an actual hike in interest rates, short-term rates may start to move higher. Consequently, credit markets may see price downside when yield curve bear flattens, however duration with determine the magnitude of downside. With Asian HY’s relatively lower duration, we expect lesser price risk as compared to other credit segments. Its higher yield-to-duration further implies that a larger rise in rates is required to erode away the its yield.

Secondly, the tightening in monetary conditions may also result in spread widening for some credit markets. In particular, those which have benefited from an environment of flushed liquidity and have seen a major plunge in spread as credit risk fades. We expect tighter monetary condition to re-introduce risks to bond markets and those with extremely low credit spread remains vulnerable to price downside. With where spread is now for Asian HY bonds, and the existing elevated risk that is priced in, the scope for further spread widening should be muted when compared to other HY segments. Therefore, downside from tighter monetary conditions maybe relatively less for Asian HY.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) has a principal position in EVERRE 8.250% 23Mar2022 Corp (USD) and EVERRE 7.500% 28Jun2023 Corp (USD).