Why are Chinese high-yield property bonds outperforming?
Guest writer Feb 22
By Michel Lowy, SC Lowy
Traditionally, investing in Asian high-yield bonds has not been for the faint-hearted. Yet in recent years a new normal emerged; just about any bond delivered strong returns. Such has been one of the results of the extremely accommodative policies of major central banks that have flooded the markets with liquidity, thereby dulling the perception of risk.
However, all this changed last year when steep falls in oil and commodities prices, together with US high-yield fund redemptions, led to a liquidity shakeout in the high-yield bond market. The new reality rewarded a discriminating investment strategy – with the Chinese property sector’s high yield bonds returning gains of 20 per cent, even as other market segments such as Indian issuers and Chinese industrials experienced single-digit losses.
This steep divergence might appear surprising. It is well known that the metals, mining and energy sectors across Asia experienced significant pain last year, but Chinese property also had its share of problems from an inventory glut to a default by Kaisa Group, a property developer.
The explanation for this curious dichotomy is that in the often opaque, Asian high-yield market, destiny is only partly defined by fundamentals.
(US$ in bn)
Source: SC Lowy, Debtwire, Moody’s
Investors need to consider not just movements in default risk but also the interplay of both the supply and demand of bonds. A good starting point with high-yield is to remember that in contrast to equities, downside protection and not earnings is the primary concern.
It is not whether a company makes its profit numbers but whether we can be sure the issuer will avoid default that matters most, because a default would wipe out any pick up in yield through the loss of principal. Or put another way, we worry about whether the glass will stay half full and not if it will ever be filled to the top.
This means that high-yield analysis tends to be company rather than sector or country specific as it comes down to accurately pricing the risk of each individual company’s likelihood of default.
At the most basic level this question can come down to whether a bond issuer has access to new financing. A distressed company in a sector with buoyant investor demand and liquidity is usually in a retrievable situation. But if liquidity support is withdrawn or unlikely, prices can drop fast as defaults become much more likely.
China’s offshore bond market, the largest in Asia, is a good example of the large role fluctuations in bond liquidity can play in performance. Last year saw a large swing in sentiment after the default by Kaisa Group aroused fears that the state was withdrawing its implicit support for property developers. However, in the event, the default proved to be an isolated case.
The main reasons for this included the fact that most Chinese property companies were replete with capital, having issued bonds in 2014 and 2015, meaning the repayment of principal would not happen for another three to five years. Another key reason was the re-opening of the domestic bond market to property developers, following a six-year hiatus.
This boosted the sector as it enabled credit profiles to be enhanced as corporates accessed cheaper funds onshore. It also helped developers to better match debt and revenue liabilities in renminbi.
A secondary impact was that as Chinese developers raised some $27bn domestically, they also stopped issuing offshore bonds and even redeemed some. This led to a tightening in supply, helping to push up prices. The sector also benefited from liquidity inflows as various investors were attracted by its relative safe haven status.
Domestically, after steep falls in Chinese equities last summer, investors switched into bonds, as they sought more defensive exposure. At the same time, traditional Asian high-yield investors also chased Chinese property names as just about every other sector was facing distress due to the ongoing commodity unwind.
Taken together, Chinese developers enjoyed a liquidity sweet spot, with dwindling offshore supply coupled with new investment inflows. Another reason for the dominance of China property is it towers over other countries and sectors in Asian high-yield universe.
Elsewhere the high-yield universe is concentrated largely in mining, energy and property spread across South East Asia, Australia and India. In these sectors few corporates have been left unscathed by the steep commodity slowdown and currency weakness.
The outlook for 2016 is clouded by elevated distress and tightening liquidity as investor interest in refinancing becomes extremely selective. Here the liquidity X factor in much of Asian high-yield is more likely to leave a sting on the downside as defaults rise. Once again, Chinese property developers remain out-performers so far.
Michel Lowy, co-founder and CEO of SC Lowy, a fixed income boutique.